Fra BNP Paribas:
A September correction, not a bear market
Although we think it is too early to call the end of the September bond market sell-off ahead of the Fed and BoJ monetary policy meetings on 21 September, we think there are supportive factors in Q4, certainly for EGBs and Gilts.
In August we warned about September headwinds for bond markets, including the resumption of supply, overstretched valuations, particularly for Gilts and US Treasuries, and less supportive central banks. As a result, we recommended a short duration trade and curve steepeners in the eurozone, and a long Gilt versus Bund position.
Since late August, 10y Bunds and Gilts, 30y JGBs and US Treasury yields have risen by between 15bp to 30bp and by significantly more compared to their summer lows. In August we warned that, after a prolonged summer trading range, long-term bonds would face temporary headwinds in September, leading to both a rise in yields and a steeper curve. Of these headwinds, valuation was the most important factor.
As we highlighted in our publication on the Gilt and quantitative easing (QE) premium last week, the decoupling between the observed change in yields and the one warranted by UK macroeconomic data and US 10y yields was at extreme levels, unseen even during the previous two Bank of England QE programmes. The US 10y Treasury term premia approach developed by the Fed has also moved into unchartered territory, and the implied premium for the Bund has periodically moved to levels not seen since May 2015.
Over the past two weeks, 10y Bund and 10y US and Gilt yields have spiked by 15bp, 15bp and 30bp respectively and, in the Bund’s case, approached our September upside target of 10bp. In Japan, the 30y JGB is back to March levels and we expect domestic investors to show interest in super-long JGBs at or near current yield levels.
However, while overstretched bond valuations mean there is a risk of a secular rise in yields or even a replay of the Q2 2015 selloff, supply and central bank variables could provide some support in Q4, especially for EGBs: 1. Supply variable: In the eurozone, October net supply, adjusted for the ECB’s public sector purchase programme (PSPP), will be the second most negative month of the year after April.
Moreover, the cumulative net supply in Q4 will be around EUR -162bn, ie 42% of 2016 net negative supply and 145% of total 2015 net negative supply (Table 1). Supply dynamics will therefore be a supportive factor in Q4, for EGBs at least. In the US, net supply, which was around USD 40bn in August and September, will also decline close to zero in October, before rising back in the last two months of the year.
2. Central bank variable: The ECB did not announce a PSPP extension at its 8 September meeting, leading to a rise in 10y Bund yields above 0 and a curve steepening, as we predicted. However, with the ECB’s QE parameters unlikely to change until December, and the ECB frontloading to resume and continue until November, monthly Bund purchases will rise compared to August, and the average maturity of monthly purchases should remain high (it reached a record level close to 11y for Germany in August, see Chart 1). Table 1: ECB QE vs BoJ – a much higher QE/net supply ratio for the eurozone and Q4 2016 numbers Chart 1: PSPP – rising average maturity of core monthly purchases BoJ Gross supply Net supply BoJ net BoJ/Gross BoJ/Net Q4-16EGB net supply 2015 166 52 80 0.48 1.5 -162bn 2016 168 59 80 0.48 1.36 Q4 /2016 42% ECB Gross supply Net supply ECB purchases ECB/Gross ECB/Net Q4-2016/2015 year 2015 900 255 380 0.42 1.5 145% 2016 818 185 570 0.70 3.08 Source: BNP Paribas Source: BNP Paribas 3 This publication is classified as non-objective research 15 September 2016 Global Rates Plus www.GlobalMarkets.bnpparibas.com
This is clearly more supportive for Bunds than a decision by the ECB to remove the depo and capital key constraints would have been. The probability of a Fed hike at its 21 September meeting is being priced in at everdecreasing levels by the market (we closed our 6m OIS payer last week), and the meeting is just a few weeks before the US presidential election. As a result, the December Fed meeting could be the last chance for a hike; three of the Fed ‘hawks’ with voting rights in 2016 will lose them in 2017, and the fourth Fed hawk will only get voting rights in 2018 (Table 2).
This means a shift to a significantly dovish Fed board in 2017, and reduces the risk of a significant sell-off in US 10y Treasuries from current levels. On the Bank of England side, our economists’ central scenario remains that of further easing in November and an additional GBP 50bn of QE. This could prevent 10y Gilt yields from rising above the 0.95/1.00% area (the QE premium has been significantly corrected).
Table 2: Three of the four Fed hawks lose their voting rights in 2017 Voting year Fed Position Ranking 2016 2017 2018 2016 2017 2018 Janet Yellen Board Chairman 1 1 1 1 1 1 1 Stanley Fisher Board Vice Chair 0 1 1 1 0 0 0 William Dudley NY Fed President 1 1 1 1 1 1 1 Daniel Tarullo Board Governor 3 1 1 1 3 3 3 Jerome Powell Board Governor 0 1 1 1 0 0 0 Lael Brainard Board Governor 3 1 1 1 3 3 3 Esther George Kansas City President – 3 1 – 3 Loretta Mester Cleveland President – 1 1 – 1 Eric Rosengren Boston President 2 1 2 James Bullard Saint Louis President – 2 1 – 2 Charles Evans Chicago President 4 1 4 Jeffrey Lacker Richmond President – 4 1 – 4 Dennis Lockhart Atlanta President 0 1 0 John Williams San Francisco President 0 1 0 Neel Kashkari Minneapolis President 0 1 0 Patrick Harker Philiadelphia President 1 1 1 Robert Kaplan Dallas President 1 1 1
Sum of the ranking 4 14 4 Ranking: neg for hawks/pos for Doves Source: BNP Paribas, ranking from -1 to -4 to hawks and +1 to +4 to doves, 0 is neutral Taking all these factors into account, a major collapse in bond markets is unlikely in the coming months, in our view, and September should see a peak in 10y yields in most markets, before a decline in Q4.
In terms of trades, as there has not yet been a bullish reversal in bond markets nor any panic selling, we keep our bearish trades in the eurozone (2y/10y swap and 10y/30y BTP steepeners, Bund put spread) and in the US (we moved our stop higher on our payer USD 10y20y swap recommendation, which is more than +20bp in the money) and closed our 2y/10y T-note flatteners (-2bp).
