16 Jan 2023
As energy prices and inflation decline across the eurozone, we explore the possibility that fixed income markets may be overestimating future rate hikes from the European Central Bank (ECB).
Soaring global energy prices and inflation in 2022 prompted a wave of monetary policy tightening and fiscal policy aimed at protecting consumers. The situation was particularly acute in the eurozone, where energy prices peaked in August 2022 at over €300 per megawatt hour, an over 250% increase from the start of 2022, while inflation peaked at 10.6%. These trends have started to reverse: headline inflation dropped to 9.2%, led by a dramatic fall in energy prices to €70 per megawatt hour as gas storage levels remain high due to a warmer-than-expected start to winter (as of 10 January 2023). We expect the decline in energy prices to filter through to further declines in both food and core inflation. Our analysis suggests that if gas prices remain at current levels, energy imports could fall from 7% of GDP to 4%, a level experienced in the early 2010s.
Eurozone inflation continues to fall as energy prices decline
Source: Eurostat as of 10 January 2023. HICP = Harmonised Index of Consumer Prices.
Despite the downward trend, inflation is still above the ECB’s target level and fixed income markets are still pricing in continued rate hikes in 2023. Although the current ECB deposit rate of 2% is the highest rate in over a decade, the ECB is behind the curve compared to many other central banks. Fixed income markets expect the ECB to catch up and hike rates by 1.5% before rates ease to a terminal level of 3% (as of 10 January 2023). However, terminal rates in the eurozone may not actually reach the market’s current projections if energy prices and inflation continue to fall. In addition, any appreciation in the euro could further ease inflation pressures as energy imports become cheaper. We may see a goldilocks situation for euro appreciation vs. the US dollar over the course of 2023, given the current significant undervaluation of the euro, the potential for safe haven demand for the US dollar to abate and declining energy prices that improve the eurozone’s balance of payments.
In the wake of high energy prices, governments committed to protecting consumers through fiscal policy, which would require them to raise debt from capital markets. However, with energy prices now falling, the amount of issuance may have been overestimated. For example, current gas prices are half the level assumed in Italy’s last budget and the cost of the Netherlands’ subsidy is estimated to have fallen from €23 billion to €5 billion, according to local press. Based on the expectation of further ECB rate hikes, the current consensus position is short duration in eurozone government debt, according to our proprietary J.P. Asset Management surveys. If inflation is indeed peaking, there is therefore room for market participants to add risk by extending duration. This comes at a time when investors are adding allocations to European government bonds: in January, inflows into European government bond funds totalled €170 million, a sharp contrast to outflows of €876 million experienced over the fourth quarter of 2022. European investors are now able to achieve a modest level of yield in their home market for the first time in a decade and may look to repatriate their fixed income allocations.
What does this mean for fixed income investors?
Until the inflation situation becomes clearer we prefer to express our view of Europe through a long euro position in currency markets rather than an overweight to eurozone government bonds. Within fixed income markets, we are moving from short towards neutral duration for European government bonds given the view that policy rate hikes from the ECB are already priced into the market. The key element to watch is energy prices; another spike in European gas prices could result in a weaker euro and higher inflation, forcing the ECB to continue hiking rates. Conversely, if energy prices remain low, the market may have overestimated eurozone policy rates.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
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