Now that breakeven inflation has rebounded sharply in the euro area (as elsewhere) and the ECB is about to start buying bonds, we expect the euro bond market to follow the same pattern as other bond markets at the start of QE, namely for bond yields to rise substantially. We expect 10-year yields to rise (initially) by some 20bp.
Since the January ECB meeting, the prospect of ECB QE has suppressed both real and nominal bond yields (Chart 1), presumably because fears of a supply/demand mismatch have outweighed any pricing-in of expectations that ECB QE will succeed in reviving inflation expectations and economic activity. But now, euro area inflation breakevens have more than reversed the fall which followed the January ECB meeting – although they have considerably further to go, even just to get back to last year’s historically depressed levels (Chart 2).
Furthermore, EUR real yields are already at, or below, the lows reached by their US and UK equivalents during QE (Chart 3), implying ECB QE is already well discounted. Therefore, we believe, the most likely course after the March ECB is for the euro area to behave as other bond markets typically do when QE actually starts; with inflation expectations rising further and nominal yields at least partly following suit (Chart 4). We recommend paying swap rather than selling cash bonds, where fears of supply/ demand imbalance may persist. We expect an initial rise of 15-20bp: in 10y swap we target 0.90%, with a stop at 0.62%.
