Despite the recent sharp sell-off of the past two weeks, Bund yields remain well below any economic value, so the past two weeks’ sell-off must be recognised as primarily reflecting changing supply/demand dynamics, as supply net of QE swings from EUR -46bn in April to EUR +45bn in May.
Future direction for yields therefore depends on whether Bunds will (1) go back to reflecting fundamentals or (2) continue to be driven by supply-and-demand.
- A return to reflecting fundamentals would imply a rise in the 10-year Bund yield of about 65bp to about 1% (driven mostly by higher breakeven inflation). So, nominal yields and breakeven inflation would have to rise a lot more before we could say that the improving fundamentals are being expressed in market pricing.
- But even if supply/demand continues to dominate, these dynamics are likely to push yields higher in the near term, before reversing in the summer. It’s hard to know how far the sell-off will go: it should be as self-reinforcing as the squeeze was (only 5% of QE-eligible Bunds are now trading below the ECB deposit rate, vs 25% two weeks ago).
Hence we expect our EUR bearish-leaning positive carry trades to continue to perform: long the belly of the 2y5y10y, short the belly of the 5y5y/10y10y/20y10y, long peripherals versus core and 10s30s peripheral flatteners versus core.
Meanwhile, both the Fed and the BoJ were quite sanguine about the weaker trajectory of growth and inflation: neither shifted its expressed policy plans in response to the softer Q1 data.
This means US Q2 data are crucial – just as they were at the beginning of the 2004 rate hiking cycle. Back then, after the release of the strong March 2004 employment report, 2-year yields rose by more than 200bp in two months. Front end valuations are more expensive now than they were in early ’04, so we add a tactical 3s10s flattener to our US bullet-vs-barbell recommendations.
