It could be a bond market correction, or the start of a rout, or the seeds of a full-blown tantrum. But it's none of these. In Europe, it's just overdone.
Friday's fixed-income selloff misses the fact that nothing fundamental has happened on the economic data front, or even politically -- we've just been talked at by central bankers getting in their "we warned you" excuses on overpriced assets. As Gadfly argued Thursday, clouds hanging over the economic and inflation outlook mean there's no realistic prospect of a change in monetary policy.
There have been technical factors exacerbating the sell-off. The set-up for the 2.5 billion pound ($3.2 billion) 10-year gilt auction next week has pushed the existing 10-year yield up 25 basis points to around 1.35 percent, and two-year U.K. yields have risen above the Bank of England benchmark rate (and are pricing in a rate hike).
An auction today of a new Italian 10-year benchmark was larger than the normal size -- and it could expand to reach as much as 5 billion euros ($5.7 billion), including the exercise of a greenshoe next week that could see primary dealers increase the size by up to 30 percent -- and that has taken its toll on existing debt.
Once these new issues are out of the way there will be room for yields to recover.
The end of the quarter and half of the year is a time for shifts in asset allocation, and it looks like here we have many investors moving in the same direction, namely, ducking out of debt. For shorter-term investors the upcoming long weekend in the U.S is also good reason to reduce risk. But there's every reason to think the start of a new quarter, when investors flush with cash can take a fresh outlook, can also soften the latest fixed-income blow.
And there is another silver lining.
For Japanese investors, the pickup in European yields make it attractive to buy foreign bonds instead of domestic government debt (which yield practically nothing), and hedge them back into yen. For the start of the new quarter there is likely to be increased re-investment from Japanese institutions that had been heavy sellers in the period before the French elections.
This has been the toughest week for the European bond markets since the lead up to the French elections in late April. As we prepare for the second half of 2017, it's time for cooler heads to prevail.
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