Global Daily – Our thoughts on the recent bond market sell-off

by: Nick Kounis , Bill Diviney

Over the last few weeks, government bond yields on both sides of the Atlantic have risen significantly. Meanwhile, today Italian government bond spreads have finally started to rise following a muted reaction to the possibility of a spend-thrift populist government. In today’s publication, we assess whether these moves will continue.

Euro Rates: Bund yields and Italian spreads to rise further – Since the start of April, German 10y Bund yields have risen by around 12bp taking them to 0.62%. The curve has steepened, with the most pronounced move in 2s10s (9bp to 118bp). We think that a number of factors explain the move in the 10y yield. Inflation expectations have risen, helped by the jump in oil prices. Caution about economic prospects has eased somewhat. Furthermore, the rise in US Treasury yields (see below) has pushed up core bond yields in the eurozone. Finally, following ECB commentary, rate hike expectations have built, however this has been further out on the Euribor futures curve, with negligible changes on expectations for the next year or so. This means the short end has been relatively well-anchored. We think that Bund yields will rise further over the coming months (3-month forecast: 0.8%). Inflation expectations are still lagging the rise in oil prices and growth expectations are likely to build again as macro data improve. These trends are likely to lead to a further steepening of yield curves (3-month forecast 2s10s: 135bp). There will also be some moderating factors. The stock of ECB purchases and weak underlying pressures should dampen the rise in yields.
Meanwhile, the 10y Italian yield spread over Germany rose by 18bp today. We think that Italian sovereign bonds are finally starting to price in the risks associated with a possible populist government. As we noted earlier in the week, the promises of the various spending/tax pledges could amount to 3-5% GDP. The measures are highly unlikely to materialise in full, however a significant fiscal deterioration looks likely. We expect a further rise in Italian spreads therefore (3-month forecast for the 10y spread: 160bp). This is also likely to lift Spanish and Portuguese spreads as well, but much more modestly. The large stock of ECB purchases and the cyclical recovery should be factors that moderate the extent of the rise in peripheral spreads generally. (Nick Kounis)

US Rates: Upside remains in the 10y, but not much – The big story in US bond markets over the past 24 hours has been the break of the 2014 post-‘taper tantrum’ high in the 10y Treasury yield of 3.05%. The 10y had hitherto struggled to break through this level. Now that it has been broken, how far can the 10y go?
We had expected 10y yields to continue their uptrend, with a year-end target of 3.20%. While we are approaching that target more quickly than anticipated, and expect strong momentum in the US economy to drive further upside, we would caution investors not to get overzealous in expecting higher rates, for three reasons. First, a significant part of the pickup in yields has been higher inflation expectations, driven chiefly by higher oil prices. We see only limited upside potential in oil prices, and if anything the risks appear skewed towards a correction in the near-term (see here). Unlike in the eurozone, inflation expectations have already risen to reflect higher oil prices. Second, the structural factors that are weighing on the long-term neutral fed funds rate, such as the ageing population, weak productivity growth, and the global savings glut, are unlikely to abate significantly. Indeed, this point was reiterated by one of the FOMC’s more hawkish members, San Francisco Fed President John Williams (soon to be the new NY Fed President), in a speech overnight. Thirdly, as the Fed continues tighten policy and markets start to look beyond the fiscal stimulus the economy is about to receive, they will also begin to price in a slowdown in growth, and this will lead to a resumption of the flattening yield curve, in our view. Indeed, we continue to expect the yield curve to invert slightly by end-2019, when momentum is likely to have cooled considerably. (Bill Diviney)