Fra BNP Paribas
Ahead of the critical ECB governing council meeting on 10 March, the backdrop is not supportive for bond markets: risk-on appetite appears to be recovering and net supply conditions are not supportive near term.
Following previous ECB meetings when rates were cut, the bond market suffered a setback driven by profit taking or disappointment with the policy measures. The risk is that a similar setback will be seen this time around. However, we expect a continuation of the recent setback to be limited. Moreover, the backdrop is likely to turn more favourable for bonds in a few weeks’ time. Trade: We booked profit on our long position in ERU7 and on 2y swap receiver.
Sell ERU6 and ERZ6 future contracts targeting 100.27 and 100.26, respectively. Buy the 2y Schatz versus OIS at 9bp targeting 17bp with a stop at 5bp. Put on a EUR 2y/5y swap steepener at 20bp and add to the position on any move to 16bp targeting 32bp. Duration The current bond market setback is being driven by a number of factors.
First, the setback is a correction of end-February’s rally that was driven by portfolios’ adjustment to the end-month large duration rise of bond indices. Second, unlike in February, net supply conditions are not favourable in March. Adjusted for quantitative easing purchases, total net supply is close to EUR 30bn in March the heaviest month in 2016 (albeit the German market will be protected by its slightly negative net supply during the month).
Third, the global environment is unsupportive. Expectations with regard to the outlook for US rates have adjusted sharply over the past fortnight as some stronger-than-expected US economic data have suggested that Fed rate hikes may still be seen this year. This has pushed up US rates, affecting EUR rates.
The near-term outlook remains cloudy. However, in addition to the factors mentioned above, there is a significant risk of a setback after next week’s ECB’s decisions, in our view. Given the wide range of permutations – encompassing changes not only to the deposit rate but also to the structure of the rate system and the size of asset purchases – it is difficult to calculate exactly what the market is pricing in.
However, the market’s clear expectation of a dovish outcome to the meeting, while in line with our economists’ expectations, leaves it exposed to disappointment. Note that a setback would follow the precedent set by previous easing decisions since 2014. These were followed by a rebound in short-term rates and, to some extent, a rise in sovereign debt yields, driven by disappointment (particularly December 2015) or profit taking on fully expected decisions
