Fra BNP Pariabas:
Several of the major central banks have shifted to a more hawkish tone, injecting a degree of uncertainty into markets. This should result in a sustained recovery of volatility, particularly in rates, which in turn supports our view for higher longer-term rates and steeper curves as term premium recovers. In the near term, these rate moves are likely to weigh on risky asset prices, especially as the Fed has referenced the current elevated valuations.
The Fed remains a key focus, given the potential for its balance sheet reduction programme to be announced at upcoming meetings. The expansion of global central bank balance sheets over the past 18 months has supported flows into risky assets. Our analysis suggests that the evolution of total global balance sheet expansion, not just the Fed’s, is important for these flows. With the gradual introduction of Fed reduction and ECB tapering policies, and continued expansion by the BoJ, support may continue for risky assets in the medium term, especially given the firm global growth outlook.
The key question for the EUR is what eurozone investors are likely to do with their foreign bond holdings. Eurozone investors have purchased a total of EUR 1trn of foreign bonds since 2014, attracted by higher yields and expectations for the EUR to weaken. We suspect many of these positions are not FX hedged. Investors may increase hedge ratios, thereby providing further EUR support, or repatriate the flows, causing the EUR to remain supported and US bonds to come under further pressure.
Fed and ECB polices are likely to have a large impact on bond markets. In our view, bond markets are starting to look complacent with respect to the upcoming drop in demand for bonds. In the US and the eurozone, the net supply of bonds will rise sharply. Rates vol and term premium will rise, but there is a more attractive opportunity in the short end: a shift toward shorter duration allocation by bond investors should see demand for 2y bonds in the major markets rise.
