Record start for Europe’s debt markets should not obscure risks ahead

Market expectations of rate cuts ‘too much’ and inflation may be more ‘volatile’

As Europe’s primary bond markets open up in January, two things are almost guaranteed: a rush of supply and record order books. However, the start to 2024 was more remarkable on both fronts given the new monetary policy environment that markets find themselves in.

The most notable transaction at the start of year – in terms of demand at least – was Spain’s new €15bn 10-year bond, which amassed an order book of €138bn. That was not only Spain’s biggest ever book but the biggest ever for a sovereign syndication. It was just shy of the most demand received in bond market history – a claim that belongs to the European Union.

‘Those earlier [EU] deals were executed during an extremely supportive environment, at the very peak of quantitative easing stimulus during Covid-19, when policy rates were negative,’ said Lee Cumbes, head of debt capital markets, EMEA, at Barclays, one of the leads on Spain’s transaction. ‘Whereas now, we have had the fastest set of rate hikes ever, plus not only has QE stopped, it’s beginning to reverse with quantitative tightening as the European Central Bank runs down its portfolio.’

What is driving demand?

That is not an easy answer as there are macro and technical reasons as well as factors specific to each credit. These are in addition to obvious factors such as rates being higher and investors keen to put cash to work at the start of the year.

First, investors are making up for lost time, following a huge rally in the European rates market towards the end of last year, where yields fell by around 100 basis points. ‘Last August, September and October, there was a challenging market for sovereign, supranationals and agencies, as the “higher rates for longer” story really began to bite,’ said Cumbes.

‘Then, not only did market consensus begin to see a peak in rates, but this quickly moved into expectations of rate cuts, much sooner than many people expected,’ he said. ‘There was a very strong rally during a moment when it was so close to year-end that not everyone could be active. Many investors are playing catch-up now.’

For Spain’s transaction, the economic story was also a key driver for demand. ‘Investor confidence in Spain’s economy is stronger than ever,’ said Mercedes Abascal Rojo, head of funding and debt management at the Spanish Treasury. ‘We have proven a strong growth track-record after the pandemic and expect to continue to do so.’

‘For 2023 we forecast that the growth rate, at 2.4%, will be three times bigger than the Eurozone average,’ said Rojo. ‘We believe that this continued growth, coupled with our commitment to fiscal consolidation, brings more and more investors to the Spanish public debt market.’ Spain has subsequently reduced its net issuance by €10bn, partly supported by its economic performance.

Market risks still ahead

Investors are also piling in to buy European government bonds at current yields before the ECB cuts rates later in the year, starts to unwind its pandemic emerging purchase programme portfolio and accelerates the pace of its QT programme. The ECB is expected to commence a series of rate cuts from the summer of 2024, but market expectations for the pace of these cuts are where some of the risks lie ahead for European government bonds.

‘The market is pricing in 150bp of cuts by both the Federal Reserve and ECB, which we think is too much at the start of the year,’ said Matthieu de Clermont, senior fixed income portfolio manager at Allianz Global Investors. ‘It could be 100bp, particularly if there is no recession in the first quarter and if core inflation is not consistently falling.’

‘Inflation discounted by markets is seen as being slowly going back to 2%, but it could be much more volatile than that especially as we enter a period where seasonal effects are less pronounced,’ said de Clermont. ‘There are also geopolitical risks that could affect supply chains and inflation. Growth could also be better than expected, which means rates could stay higher. We all agree that central banks’ interest rate rises are over but what we don’t know is what the new level will be.’

Borrowers must not get carried away by the record start to the year. It will get tougher. Nevertheless, Rojo remains confident for the year ahead.

‘Going forward, we expect the stability of government debt markets to continue,’ she said. ‘Markets will continue to adapt to new information, because there is still some uncertainty on the future of inflation and growth internationally, as well as the rate-path to be followed by the main central banks. However, all in all we believe the market is supportive, and the high demand of our transaction keeps us confident for the execution of our 2024 funding strategy.’

Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.

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