Thursday, March 15, 2012

Trend Change in 10y Bund yields

The easing of financial market stress is continuing. In fact, the ECB has managed to break the former downward spiral where higher peripheral government bond yields lead to a worsening in fiscal solvability, more austerity programmes and weaker growth. Additionally, lower government bond prices weaken bank balance sheets which increases the need to deleverage and also reduces growth. Lower growth, however, further weakens fiscal solvability and leads to higher yields for peripheral government bonds.
The ECBs action, however, have managed to improve the position of banks and of sovereigns alike. Lower yields for peripheral sovereigns improves fiscal solvability and lower the need for additional austerity measures. Furthermore, higher prices for peripheral bonds improves banks' balance sheets and reduces the need to deleverage. Hence, there is now a weak form of an upward spiral in place.
Overall, these actions have helped to stabilise the macro-economic environment in the Eurozone. Furthermore, sentiment indicators can rise from formerly depressed levels and expectations for Eurozone growth should start to improve as well.
As a result, financial markets can now enter the second phase of the easing in financial tensions. Whereas the first was driven mostly by the surge in liquidity where all asset prices can rise, the second phase should be driven largely by the improvement in the macro-economic environment. This means that so-called risky assets (i.e. peripheral bonds, credit bonds, equities) should continue to perform and dips should continue to be bought. However, the so-called safe-haven assets (i.e. Bunds, but also precious metals, JPY, USD, CHF) should increasingly come under pressure and upticks should be sold. For one, investors will start to actively switch out of these assets into risky assets to profit from an improvement in the macro outlook. Additionally, as the outlook improves, expectations for another ECB rate cut will vanish. Furthermore, I expect inflation expectations to start rising. The ECB will face huge difficulties to drain the excess liquidity (to the tune of EUR 900bn) it has created via the two 3y LTROs. Most likely, if it were to actively drain this liquidity (via a rise in the reserve ratio or reverse auctions/issuance of bills) it could do so only with the help of significantly higher short term rates which, however, will be very difficult to achieve amid the persistent weakness in parts of the peripheral countries' banking sectors. Most likely, the level of excess liquidity will remain very high for the foreseeable future and hence this liquidity will continue to slosh around the financial system and drive up asset prices in turn. As a result, inflationary pressures should rise and be reflected mostly in rising break-even inflation rates at the longer end of the curve. Hence, the yield curve should bear-steepen, driven by higher yields for long-term Bunds.  Fundamentally, therefore, longer-term Bund yields should rise markedly in the months ahead. The underperformance of Bunds vs. peripheral and corporate bonds should continue.

Trend change in 10y Bund yields
 Source: Bloomberg

Technically, the picture for Bunds now shows first bearish signs as well. As the chart above shows, 10y Bund yields are still within their 1.74-2.02% range they have been trading at for the past few months. However, earlier this week, they have finally broken through the downward trend which was in place for almost one year. I take this as a first sign that investors have started to shift out of Bunds into other (more risky) asset classes. Furthermore, this assessment is confirmed by a simultaneous flattening of the peripheral curves. While the first phase of the liquidity glut was marked by steepening peripheral curves (as some money from the 3y LTROs found its way into shorter-dated peripheral bonds), the second phase should be marked by ongoing spread compression mainly at the long end as investors increase risk taking.
Overall, I think that markets have entered a second phase of the easing in financial tensions which will see ongoing performance in risky assets but safe-haven assets will come under increasing pressure. 10y Bund yields are likely to rise back towards 2.50% in the months ahead.