By Stefano Rebaudo
(Reuters) - Investors have rapidly revised up their expectations for euro zone interest rates, but with a peak now in sight, governments might find it much easier to allocate record bond sales thanks to a cocktail of attractive yields and available liquidity.
Against that backdrop, portfolio managers have been leaning more towards fixed income investments, which has boosted appetite for government bonds.
“There is an almost unanimous agreement that investors will increase their strategic asset allocations to all sorts of bonds, which is helpful to the marginal liquidity story, so far preventing (bond) supply from applying upside pressure on yields,” said Niall O’Sullivan, CIO of multi-asset strategies at Neuberger Berman.
Meanwhile, the European Central Bank (ECB) is likely to be cautious in its efforts to tighten up credit conditions so as not to disrupt supply-demand dynamics for the fixed income market. Traders are confident the ECB will have a smooth start to unwinding its huge bond holdings, a process known as quantitative tightening (QT).
“Government bonds became attractive after the repricing of the last few months, and we know the ECB will be cautious with its QT measures,” said Luca Bindelli, head of global fixed income, forex, commodity strategy at Credit Suisse.
“Appetite for bonds should be enough to absorb 2023 record net supply,” he added.
Bond demand is set to accelerate as markets increasingly price in a peak for yields.
However, if this repricing slows down, that might erode demand for bonds from yield-hungry investors, which could push up borrowing costs again, particularly over the medium term.
“The euro area keeps having excess liquidity and is able to fund smoothly the government bond supply expected for this year,” said Erjon Satko, rates strategist at BofA.
“The only issues are the timing and the rate outlook. A slow bear-market trend might stall demand, putting the belly of the curve at an increased risk of a sell-off,” he added.
In the space of a month, repricing in the money markets has led traders to factor in a peak ECB depo rate of 4.1%, up from closer to 3.5% a month ago, while Bund yields have staged one for their fastest increases in decades in recent weeks.
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EXCESS LIQUIDITY AND DEMAND-SUPPLY DYNAMICS
Two significant factors that might curb excess liquidity are national treasuries reducing the cash they hold, which skyrocketed during the COVID crisis, and commercial banks repaying ECB longer-term refinancing operations (TLTROs).