(Bloomberg) -- A hedge fund manager who made the right calls on inflation and the Federal Reserve’s rate hikes is selling European government bonds on a bet that interest rate cuts are being overestimated by the market.

The euro-region’s economy is more resilient than the market is anticipating and the European Central Bank will cut rates just once or twice this year, less than markets are pricing in, according to Alberto Gallo, the chief investment officer of Andromeda Capital Management. 

Europe is unlikely to enter a recession when governments in the region are spending more, US growth remains robust and China continues to stimulating its economy, said Gallo. He left Algebris in 2022 to help set up the fund, which now manages $200 million in assets. 

German bund yields are too low for such an environment and the 10-year rates are likely to rise to 2.75% to 3% this year from about 2.5% now, he said. Gallo sees 10-year US Treasury yields rising to 5% and expects no rate cut from the Federal Reserve this year.

“It’s hard to see the ECB cutting as much as the market is pricing,” he said in an interview. “The European economy might not be growing as fast as the US, but it’s not collapsing. Buying German bunds at current yield levels won’t give you any protection against inflation.”

The money market is pricing three quarter-point cuts by the ECB this year, with a small probability of a fourth reduction. Most analysts expect the ECB to cut in June to offer some support for growth, but what happens after that is uncertain. That’s partly because Fed signaled this week it will wait longer than previously anticipated to reduce borrowing costs following a series of surprisingly high inflation readings.

Divergence Limits

Gallo has a history of being right on big calls. Back in 2021, he correctly predicted that the Fed would hike interest rates aggressively the following year because inflation was not as “transitory” as many market pundits envisaged at the time. He was also among the first investors who reckoned the Fed may not cut rates at all this year.

Andromeda’s flagship credit long-short strategy, which focuses on relative value across bonds and credit while minimizing potential volatility, had a net gain last year of 8%. The strategy has a beta value of 0.03; a value below 1 implies less volatility than the wider market.

German 10-year yields fell 2 basis points to 2.47% on Friday as concerns about a conflict between Iran and Israel drove demand for haven assets. Gallo said while the tensions in the Middle East may suppress yields for now, rising oil and commodity prices would mean persistent inflation for the region in the medium term.

Shorting European government bonds will also give investors a bigger bang for their money because long positions are looking stretched, he said. The consensus strategy now is to buy euro-region bonds against US Treasuries in a so-called “divergence” trade whereby the ECB is expected to cut rates at a much more aggressive pace than the Fed.

“There’s only so much the two economies can diverge,” said Gallo. “And eurozone yields have lagged. The next leg higher in yields will come from European government bonds.”

(Update with previous calls and fund performance, starting in the first paragraph.)

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