The Big Picture: Not as straight forward as it appears on first glance
Most market participants inherently hold a bond market friendly bias. Central bank rates have likely peaked, inflation is receding and the growth outlook weak. Yet, we argue that when digging deeper, the bond market bullish case is not as clear cut. We still prefer longs in short dated credit over duration exposure, expect the curve to steepen in most market scenarios and ASW to tighten under the weight of bond supply.
Euro area economics and ECB: Waiting for the dust to settle
Euro area GDP growth likely started 2024 on a soft footing. Activity, however, is likely to modestly strengthen as the year progresses aided by a recovery in household consumption. A rebound in the contribution from energy will keep headline inflation supported in the near-term before it resumes its descent in the latter half of the year. The ECB is likely to be cautious about prematurely declaring victory over inflation and we expect it to keep rates unchanged for entirety of 2024. We think, however, that the ECB is unlikely to wait until the end of 2024 to stop PEPP reinvestments and expect an early end to be announced, most likely in the spring.
UK economics and BoE: Can you have a soft landing if you never really took off?
We expect UK GDP growth to remain broadly flat in the near term as the continued impact of BoE policy counters that of rising real wages. For the BoE, with inflation increasingly domestically concentrated, bringing it down further from here will be more difficult and likely entail a more material slowing of wage growth than hitherto seen. We continue to see the BoE on hold through 2024 with the conditions in which the MPC would feel comfortable cutting Bank Rate only presenting themselves in early 2025.
Gilt demand/supply outlook
Higher net gilt supply for the market to digest will continue to be a feature of the gilt market for the foreseeable future. UK swap spreads are yet to fully reflect this change and hence we think spreads can continue to cheapen across the curve. Given the heightened gilt sales requirement from the DMO, we think they will continue to keep the average maturity of their gilt issuance towards the historic lows which will allow long-end spreads to continue to outperform into mid-2024. Additionally, the ending of the BoE’s hiking cycle along with continued QT, higher gilt issuance and a slowing housing market will continue weigh on short-end spreads which currently look far too rich in this environment.