Head - Fixed Income Strategy
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We expect a continued rise in European rates and stay underweight
Ten-year German Bund yields doubled over the last several weeks, as European Central Bank President (ECB) Mario Draghi’s comments during a June speech implied a relatively more hawkish tone. Moreover, subsequent ECB minutes from their June policy meeting fueled the sell-off further. The minutes implied that next steps may signal a possible decline in monthly bond purchases. The next ECB meeting is set for 20 July.
Consequently, 10-year Bunds have moved 35bp to 0.60%, losing nearly 3.0%. This has also narrowed the spread versus US Treasury yields to its tightest level since November 2016. Though this sell-off is not on the same scale as the 2015 Bund taper tantrum – where 10-year Bunds lost 7.5% – this is now the 3rd time in the last 6-months where long-dated German Bund yields have lost more than 2.5% over a short period of time.
With its balance sheet now exceeding that of the US Federal Reserve, the ECB remains the largest net buyer of EZ sovereign debt. Indeed, Italian government bonds bought between March 2015 and April 2017 totaled €255bn, three times as much as net debt issuance over the same period (€78bn).That said, issuer limitations have created problems with the central banks’ ability to source bonds in certain countries, like Germany. Despite lowering their monthly purchases in April to €60 billion from €80 billion, recent data from the ECB showed it fell short of its target purchases of German Bunds for the third straight month.
In order to avoid reaching issuer limits under the asset purchase program, a further tapering of bond purchases could be announced later this year, and likely not implemented until 2018. Considering the significant technical presence of the ECB, we would expect markets to discount the decline in indiscriminate flows, pushing core rates higher. With the average yield on 10-year core EZ sovereign bonds still at an anemic 0.7%, we maintain our underweight in the region.