Tuesday, September 22, 2009

Rates Strategy: A look at the relative value of 10y Bunds

I have received several questions with respect to the movement in 10y UST-Bund spreads as well as of inflation expectations. In this post I try to shed some light on this. As a warning: this is a bit of a technical post and might only be suited to rates nerds (such as me).

Essentially since the middle of July US break-evens have traded in a range whereas Eurozone break-evens incorporated into benchmark bonds have moved continously higher. On the other side, US as well as Eurozone real yields have fallen.
US: 10y break-evens in the middle of the range, 10y real yields close to recent lows
Source: Bloomberg

Eurozone: 10y break-evens close to wides, reals close to lows
Source: Bloomberg

However, why Eurozone break-evens should outperform vs. their US counterparts seems a bit of a mistery given the appreciation of the trade-weighted euro of some 2.5% over the past two months vs. a depreciation of approx. 3% of the trade-weighted USD. Furthermore, why have real yields in the US and the Eurozone both fallen given that during this period growth expectations as well as equity markets have improved considerably?
In early July I suggested that 10y Bunds were expensive vs. 10y US Treasuries (see Rates Strategy: Digging below the surface). A key reason was that the liquidity premia incorporated into nominal Bunds was high relative to the premia incorporated into 10y US Treasuries. The chart below tries to show this. It shows the spread between 10y inflation swaps and 10y break-even inflation rates incorporated into US Treasury and Bund inflation linked bonds. Before the financial crisis this spread has been trading around the 40bp level in the US. However, during the height of the financial crisis this spread moved sharply higher as nominal US Treasury bonds were the safe haven and inflation linked bonds lost in relative value, depressing the implied break-even inflation rate by even more than the inflation outlook warranted. In turn, the spreads to inflation swaps shown below reached record historical levels early this year. Effectively, this meant that inflation priced into inflation swaps was far higher than the same inflation priced into similar maturity inflation linked bonds.
Difference between inflation priced into government bonds and inflation swaps as a liquidity premia
Source: Research Ahead

However, starting in March just as equities hit bottom, these spreads started to normalize again with a significant countermovement in May, before a renewed tightening trend set in. Since mid July, this spread tightened slightly, by approx. 5bp in the US. But in the Eurozone the spread tightened by a massive 25bp!
The tightening of this spread happens via an outperformance of inflation priced into government bonds relative to inflation priced into inflation swaps. As Eurozone inflation swaps did not move during this time period, break-even inflation rates priced into Eurozone linkers had to rise. Furthermore, with nominal bonds not moving much, real yields fell. Given this, I would assume that Eurozone inflation expectations did not move over the past two months and the rise in break-evens was due to a relatie cheapening of nominal bonds (amid a lower liquidity premia).
Source: Bloomberg

Additionally, this cheapening of nominal Bunds vs. linkers was also accompanied by an outperformance of 10y US Treasuries vs. Bunds as well as by a relative steepening of the Bund curve vs. the US curve as shown in the chart below.
5-10y Bund curve outsteepened UST curve
Source: Bloomberg, Research Ahead

My conclusion from all this is that Eurozone real yields and break-even inflation rates priced into inflation linked bonds are now more closely reflecting again inflation expectations as the (negative) liquidity premia has been reduced. Furthermore, I think that 10y Bunds look fair value again relative to their US counterparts from this perspective. This suggests that the relative underperformance of nominal Bunds on their own curve (i.e. the steepening seen in the 5-10y area of the curve) should soon stop and flattening positions have become more attractive again in the 5-10y area.

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