Over the past month, UST and Bund yields have fallen significantly. I maintain my strategic long duration outlook amid expectations for only a muted and temporary recovery as well as the absence of any meaningful inflation pressures. However, there are several noteworthy developments which lead me to conclude that German Bunds appear a bit expensive from an RV perspective and are likely to consolidate before taking another leg higher:
The drop in 10y UST and Bund yields since June 10 was of similar magnitude (51bp vs. 42bp). However, in the
Why this diverging behaviour? I guess that the outperformance of US Swaps is largely down to an unwinding of convexity hedging performed in swaps during the previous sell-off (remember: convexity hedging amplifies swings in yields as it leads to swap receiving during a bull-market and swaps paying during a bear-market). The chart below compares the development of 10y US and 10y Eurozone swap spreads. During the risk-recovery period since mid March, swapspreads tightend in the
Where to go from here? I remain bearish on inflation-linked products on a medium-term basis. However, amid the significant difference between break-evens priced into inflation-linked bonds and the level of inflation swaps, it is much more the latter which should drop and here especially EUR inflation-linked swaps appear too high. I do not see how inflation pressure can be rising if risk aversion is rising, commodities are falling and the green shoots are turning yellow which puts a dampener on recovery hopes.
UST and Bund yields can drop further over the medium term. Positioning in the
So, strategically I remain bullish on UST and Bunds but from a tactical perspective I move to a neutral stance and look for an underperformance of Bunds.