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Time is running out for bond market bullishness

Running out of time HiRes 575

Negative real rates and a borrowing binge spell trouble

Fuelled by falling headline inflation and a more sanguine view on the prospects of a recession, credit markets have been on fire.

The rally still has legs — but with core inflation that could well prove stubbornly above target and the government borrowing binge only just under way, its days are numbered.

This week the iTraxx Senior and Sub Financials indices hit new four-month lows, with respective spreads of 87bp and 154bp nudging half their peak.

Last year’s growth predictions had been dire, but with China out of lockdown and on the road to recovery, a new sense of optimism has developed.

The more constructive view was underscored this week by BNP Paribas, which raised its 2023 European growth forecast from a negative 0.5% to a positive 0.2%.

However, its chief economist warned that underlying inflationary pressures would be “harder to tame”, meaning the European Central Bank will be obliged to raise rates to 3.25%, rather than the 3% they had initially expected.

The ECB’s more restrictive stance will take months to filter through to the real economy — but, more importantly, the influence of quantitative tapering and its withdrawal from the Targeted Longer-Term Refinancing Operations have not even begun to surface.

From March the ECB will cut purchases under its Asset Purchase Programme by half, equating to €15bn a month. And in June about €1.3tr of cash borrowed by banks under the TLTRO, will be returned. Since some of this cheap money will have been invested in government bonds, you can count on a knock-on impact in that market.

The withdrawal of this bid comes amid an expected flood of sovereign issuance, much of which is likely to be from Germany and Italy in the long end, where investors are particularly sensitive to locking in negative real rates of return.

On February 1 markets will get a wake-up call as January’s eurozone headline inflation rate is broadly expected to rise from December’s 9.2% pace.

At some point, investors might begin to ask themselves why they are still buying Bunds that deliver a miserable return of about 2% for five years and beyond.

Higher borrowing costs, tighter credit and lower earnings are plain to see. It’s really only a question of time before markets wake up to this.