An earlier ECB pivot presents yield curve opportunities

I’m Javier Corominas, Head of Global Macro Strategy here at Oxford Economics. Term premia has been on the rise recently and while no single factor can explain the move higher, we think a combination of factors are probably at play. We think news of increased coupon sizes has already been digested by the market, and the end of Japan’s YCC policy is a slow burn issue really tightly managed by the Bank of Japan for now.rnrnTrue, 5y5y inflation expectations remain above central bank target rates, but they have been stable for months. In fact, we think the curve repricing higher is as much a term premia story as a real rate adjustment story. And at 2.4% these real rates are well above US trend growth rate over the medium term. However, we think the opportunities lie elsewhere at the shorter end of the curve and in the eurozone.rnrnWe think the higher for longer mantra that the market is extrapolated to the eurozone from the US is misplaced. Yes, core inflation will remain sticky over the next few months thanks to services inflation remaining high. But leading indicators do suggest a softening of the eurozone labor market going into 2024. Furthermore, still falling wholesale and electricity gas prices will keep inflation trending down over the next three months.rnrnAnd we think more importantly that the market consensus and the ECB have not factored in these dynamics. Where we think inflation will hover around 2% next year rather than the above 3% priced in by markets. So we think we have an opportunity here in two year German yields where we see them dip sustainably below 3% as we move into 2024 and we also think a bull steepening of the German curve is warranted.rnrnTogether, these are two key non-consensus trades going into next year.