Fra BNP Paribas:
The Brexit vote is likely to shave about 0.5% off eurozone GDP in 2016-17, according to our economists, strengthening the argument for an extension of the ECB’s PSPP. However, an extended PSPP could lead to a change in the ECB’s QE parameters, triggering an underperformance of Bunds versus both swap and US Treasuries.
In contrast, the prospect of a slowdown in US economic growth in H2 2016 is not fully priced into US long-term rates. A weak non-farm payroll (NFP) figure on Friday 8 July could trigger a further fall in rates. In the short-term a close to target NFP could produce a ‘relief’ sell-off. However, we see any setback as an opportunity to re-enter 10y Treasury longs in the 1.50% to 1.60% range.
Last week’s return of the risk-on mood proved short-lived: we booked profits on our risk-on trades (see the eurozone spread section).
We expect the 10y US Treasury-Bund spread to continue to tighten, while the divergence between core eurozone and US ASW has ended.
Trades: For the first time in a long time, we recommend a structural long position on the US 5y ASW and a short German ASW through the BUXL ASW. We also recommend buying some protection on Bunds. After an initial sell-off following the unexpected Brexit vote on 24 June, US and, to a lesser extent, eurozone risk assets rebounded last week.
However, US and core bond yields have largely shrugged off the rebound in risk assets and remained close to their lows. The impact of Brexit on the eurozone economy should not be underestimated; our economists forecast it will shave 0.5% off eurozone GDP over 2016-17 by fuelling uncertainty (especially as the UK appears in no rush to invoke Article 50), hurting trade and tightening monetary and financial conditions.
Against this backdrop, eurozone core inflation will be lower than previously forecast. This environment supports the case for an extension of the European Central Bank’s asset purchase programme (APP). However, with yields on almost 60% of Bunds below the deposit rate, the ECB will have to either loosen its rules ‒ which could mean reducing purchases of German paper ‒ or expand its asset basket like the Bank of Japan did, which would be negative news for long-dated Bunds.
In the US there have been increasing signs of a weakening in activity in recent quarters. While the S&P 500 has been supported by buybacks, US corporate earnings have declined, which bodes ill for future capital expenditure and jobs outlook (the US Federal Reserve’s Labour Market Index is now declining – Chart 1).
June non-farm payroll (NFP) data could prove to be a market mover, as another disappointing number could trigger doubts over the US’s H2 2016 economic outlook. As a result of the above, new trends could be in sight: The one-year bull market on the 10y Bund could end if the ECB changes the rules of its quantitative easing programme (QE).
When, back in February, we first called for a fall in the 10y Bund yield to the -20bp level, it was seen as a very aggressive call. While the yield level has fallen sharply close to this level, QE rule changes could reduce fears of scarcity and see the 10y Bund ‒ at best ‒ stabilise in a trading range in the coming weeks.
In ASW, the divergence between a cheapening of US Treasuries and a richening of Bunds versus swap could have come to an end (Chart 2). In the US, net supply after Fed purchases will be down 72% in 2016, while in the eurozone scarcity fears should recede. The narrowing of the 10y US Treasury-Bund yield spread could accelerate.
If June NFP data are again on the weak side, the narrowing of the 10y US TreasuryBund differential could accelerate on increased purchases from Asia (the net buying of US long-term securities from Japan has accelerated in 2016 – Chart 3)
