BTPs to buy quickly, before the ECB rate cut

Whether the first ECB rate cuts are in April or June does not change the underlying setting of the bond market: in the coming months, when the ECB changes its tone in the words used in press conferences and becomes more accommodating, then there will be no need to wait for the real reductions of rates to "taste" another rally in the world of bonds (like that of the October-December 2023 period), because the rally will start again as early as February-March of this year.
So buy extra-long, high-coupon bonds now.
At the end of the article there is a selection of the best BTPs to buy in this context.
The European Central Bank (ECB) meets on Thursday and board members, not yet ready to declare victory in the inflation battle, are fighting among themselves over who can best influence traders' bets on a rapid rate cut – some cooling down expectations, others lighting up hopes.
The markets, observing the futures curve on the overnight rate, are aiming for a first cut in April, but the ECB wants to see more evidence of a slowdown in price growth before pressing the "release" button of the first fateful 25 basis points.
There are many open questions still awaiting interpretation of the language of Lagarde's press conference on Thursday.
First, let's be clear that the ECB will do nothing: it is certain to keep rates on hold, after halting rate hikes in October and making clear in December that it would phase out its pandemic-era bond-buying program (the PEPP).
in the second half of 2024.
Analysts expect Christine Lagarde to continue to signal that it is too early to discuss rate cuts – a message that does not fully resonate with traders, who continue to expect cuts of 150 basis points over the next 24 months , starting from April 2024.
read also The best European government bonds to buy today Lagarde has already warned that an excessive number of cuts could damage the fight against inflation.
However, many members of the directorate also recognize the need for "humility", that is, not to take rigid positions as of now, but to wait for the macroeconomic data, given the uncertainties that await us, such as those linked to the war in the Middle East , the riots in the Suez Canal, the war between Russia and Ukraine, etc.).
The most important question, therefore, is the following: will the ECB change course soon or not? The markets think so.
Operators simply postponed their expectations on the timing of the first cut, moving it to April compared to March, and expect one less cut (150 bps instead of 175 bps) compared to last month, during the two-year period 2024-2025.
Even the "hawks", i.e.
the members of the governing council who are less soft on monetary policy, such as the German Joachim Nagel, do not rule out an initial summer move.
A change in tone, towards more conciliatory attitudes with a more expansionary monetary policy, seems to be only a matter of time.
The "IF" is not in doubt, only the "WHEN".
However, the ECB will publish new inflation and growth forecasts in March, which could lay the groundwork for starting discussions on possible easing.
Then there is also another question: how much must inflation fall before cutting rates? Euro zone inflation rose in December for the first time since April, reaching 2.9%.
Core inflation – net of the energy component – has fallen further, but is still above 3%.
It is likely that the ECB will want to see headline and even core inflation below 2.5% to be sure that the 2% target is achievable and within reach, before actually cutting rates.
Investors, however – considering the speed and intensity of the increases in 2022/2023 – are more confident of victory over inflation in the short term.
In fact, if we look for example at inflation swap contracts (contracts in which two counterparties exchange fixed rate payments for variable rate payments linked to an inflation index, calculated on an underlying notional capital), these “inflation” contract markets swaps” indicate inflation just above 1.5% within a year.
The only brake on the ECB's decision is that it could be pushed towards rigidity based on the impact of tensions in the Red Sea, which already highlight how supply chain shocks are becoming increasingly frequent, with consequences of rising prices, especially of foodstuffs and then of industrial components.
Furthermore, another brake for the ECB to initiate the first rate cut is wage dynamics.
The ECB has identified wages as the main inflationary risk.
If unemployment remains at historic lows, it means that the demand for labor from companies is still robust and therefore they are willing to grant salary increases in order to grab a still scarce workforce.
The opposite of what happens when the supply of labor exceeds the demand for labor and the unemployment rate rises.
However, let's not forget that wage growth fell from 5.2% in October 2022 to December 2023, an Irish central bank wage indicator shows, but rose to an annualized 3.8% in December 2023 versus September 2023.
Economists believe this is due to the new wage agreements.
The ECB will likely evaluate first-quarter 2024 contract renewals to see whether wage growth falls towards 3% per year, growth it considers – historically – to be very consistent with 2% inflation, before signaling a change in policy .
Lagarde expects sufficient data for "late spring" and chief economist Philip Lane wants to see data expected in April.
If wage dynamics prove buoyant, this would rule out a rate cut before June.
Yet I think that a lot depends on the inflationary expectations present in the unions and in the workforce: the decline in overall inflation in recent months contributes to the fact that inflation expectations are stable or even downwards, so all this indicates wage moderation in demands trade unions.
But the fundamental question is also another: how worrying is the eurozone economy for the ECB? In fact, I understand that for the institute, concerns about inflation still prevail over concerns about growth.
Of course, if Mario Draghi had still been at the helm of the ECB the orientation would probably have been the opposite, but unfortunately things have changed.
With the economy seen in a shallow recession, expected to have shrunk by just 0.3% in the fourth quarter, whether rate cuts begin in April or the summer will make no real difference.
Right? Yes, but this helps us to better manage bond investments.
The best BTPs to buy before the ECB rate cut If you are a trader, you should know that – for the same duration – the BTP with a higher coupon is more reactive in rising the price than the BTP with a lower coupon.
Let's take two examples of my favorite BTPs at the moment which are the thirty-year BTP and the twenty-year BTP.
Let's start with the 30-year maturity.
Let's simulate a reduction in rates of -0.40%, i.e.
40 basis points (not far-fetched in the immediate future) and see the resulting profit in terms of price in two BTPs with different coupons but of the same duration.
Just solve the problem with a regular bond calculator.
On January 22, the BTP 4.50% OCTOBER 2053 prices 102.50 and yields 4.40% gross upon maturity.
If the rate falls to 4%, i.e.
40 bps, the price rises to 109.50.
With a profit of 700 basis points (109.50 – 102.50 = 7.00).
The BTP 2.15% September 2052 – with a very close duration – today prices 66 cents which is equivalent to 4.25% gross at maturity.
If rates continue to fall by 40 bps to 3.85%, the price will rise to 71.50 cents.
With a capital gain of only 515 basis points.
So: if I have to take the risk of a thirty-year bond then it is worth betting on 4.5% October 2053 and not on 2.15% September 2052.
It is a problem of convexity of the yield/price curve associated with the two bonds in question .
The convexity of the 4.5% October 2053 bond is greater than the convexity of the 2.15% September 2052 bond, and therefore responds more promptly to the same drop in rates.
But let's not get into too technical questions.
Let's move on to the 20-year portion of the yield curve.
My favorite security in this part of the curve is certainly the BTP 4.75% September 2044.
Today it is worth 106.75 and yields 4.30%.
If rates continue to fall by 40 bps to the 3.90% level, the price rises to 112.50.
A capital gain of +575 basis points.
While the 1.50% April 2045 BTP is worth 62.75 and yields 4.20% (despite being longer it yields 10 cents less because it is a "Green" type BTP, the proceeds of which are intended to finance expenses supported by the State with positive environmental impact).
Then, if rates always drop by 40 bps from 4.20% to 3.80%, the price rises to 67.05 with a profit of "only" 430 basis points.
Decide now (not in a month or two, when prices will have already risen) to enter into securities over 10 years and with a high coupon.
This is a good time, if your risk profile is adequate and if you do not need to disinvest in the short term you could secure good profits within 9-12 months.
Or take advantage of it now, that is, buy a nice thirty-year annuity now, to guarantee yourself a nice life annuity, taxed only at 12.5%, and as an excellent alternative to that life annuity that your insurer promises you with those life policies full of commissions and costs of much heavier loading.
If you have followed my advice in my previous articles that I wrote on BTPs, and if you have already bought long-term BTPs since September 2023, articles in which I strongly recommended the long-term part of the BTP curve, then continue to accumulate and don't sell now (you would do so too soon) because there is still room for further capital gains.
read also Bonds are back (as we predicted).
Here's what to do now DISCLAIMER The information and considerations contained in this article should not be used as the sole or main support on which to make investment decisions.
The reader retains full freedom in his own investment choices and full responsibility in making them, since he alone knows his risk propensity and his time horizon.
The information contained in the article is provided for informational purposes only and its disclosure does not constitute and should not be considered an offer or solicitation to public savings.