16 September 2021
The channel widens
Recent economic data prints in the UK and Europe suggest the potential for a divergence in the monetary policies of the Bank of England (BoE) and the European Central Bank (ECB).
Fundamentals
Inflationary pressures have surprised to the upside to a greater extent in the UK than in Europe. The UK Consumer Prices Index (CPI) rate rose from 2% in July to 3.2% in August, the highest level since March 2012, beating consensus expectations and the BoE’s forecast of 3.0%. A low base, rising core good prices and strong underlying services inflation contributed to the rise. Eurozone headline inflation rose to 3% year on year (yoy) in August, and the core Harmonised Index of Consumer Prices (HICP) rose to 1.6% yoy. However, we believe inflationary pressures in the eurozone will be less persistent than in the UK because underlying pressures, such as wages in Italy, Germany and France, remain low. Labour market data was also strong across both regions. The number of payrolled employees in August in the UK recovered to the pre-pandemic level, the unemployment rate continued to fall to 4.4% in July and the trend in underlying wage growth continues to shift higher. The euro-area unemployment rate reached 7.6%, close to pre-pandemic lows, although we anticipate that growth is peaking at elevated levels (Germany, Italy and France are all within 3% to 4% of their pre-Covid GDP). The rapid improvement in the UK labour market coupled with rising inflation that is set to overshoot well into 2022 opens up the possibility of more hawkish communication from the BoE. In particular, while the centre of the Monetary Policy Committee (MPC) sees “necessary but not sufficient” conditions for rate hikes as having been met, this could change in the near term with two new joiners. This leads us to believe that quantitative easing (QE) should wind down this year, with a first interest rate hike in Q2 2022. In contrast, the softening momentum in Europe has seen very clear forward rate guidance from the ECB: no rate hikes on the horizon. Moreover, last week the ECB Council decided to reduce the pace of the Pandemic Emergency Purchase Programme (PEPP) to a “moderately lower pace” of approximately EUR 70 billion in Q4 2021 (with further reductions anticipated next year and a temporary step-up in the Asset Purchase Programme (APP) at the close of QE). The market took this as a dovish reading.
Quantitative valuations
We expect Gilt yields to be biased upwards towards the end of the year, while we are more constructive on European bonds. This is primarily due to the divergence in monetary policies between the two economies. Specifically, the chart shows an interest rate hike of 15 basis points (bps) priced in by February 2022 in the UK, and a cumulative 45 bps by November 2022. In contrast, there is little priced into the eurozone before 2023, with the ECB’s forward guidance remaining very dovish. UK Gilts (currently at 0.78%) have risen 22 bps since the beginning of August, while 10-year German Bunds (currently at -0.31%) have moved 15 bps higher. Gilts yields have more room to meet our year-end forecast range of 0.875% to 1.125% when compared to Bunds, where our forecast is -0.30% to 0%. As such, over the next months we anticipate the UK, as one of the earliest developed market hikers, to underperform. (Data as of 15 September 2021).
A clear rate hike trajectory is priced into UK yields compared to eurozone yields
Source: Bloomberg. As of 15 September 2021.
Technicals
The dovish reassurances from the ECB that the PEPP purchase pace for Q4 would only be “moderately” below the recent pace creates a stronger technical backdrop in Europe than in the UK. Gross euro-area government bond supply net of QE was greatly reduced in August and should remain favourable next year, with rough estimates at approximately EUR -40 billion. In contrast, net supply in the UK is expected to increase in 2022 to GBP 125 billion, up from GBP 49 billion, with greater net Gilt issuance coupled with a winding down of Asset Purchase Facility (APF) new purchases. Looking at demand, we have witnessed consensus short positioning in Gilts reinstated following the summer months. In Europe, however, duration positioning for semi-core rates is overall positive and new issues come with reasonable new issue premiums. The notable exception is Germany, where the upcoming election creates a hawkish risk with expectations of fiscal expansion under a SPD-led coalition.
What does this mean for fixed income investors?
We believe the divergent paths of monetary policy between the BoE and the ECB, driven by different inflation trajectories and wage pressures in the UK and Europe, should translate into European government bond yields remaining range-bound while Gilt yields inch higher over the remainder of this year. As such, consensus long positioning in German Bunds versus Gilts should be monitored in tandem with further central bank guidance over the remainder of the year.
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.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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