Bund Flattening Defying Textbook Highlights ECB Angst: Analysis

Short-end bonds’ room to rally further limited unless QE purchase rules changed

Euro-area disinflationary pressure is getting deeply entrenched. With shorter-end bunds already pricing in further European Central Bank easing, the recent curve flattening shows ineffectiveness of policies in boosting inflation and nominal growth, Bloomberg strategist Tanvir Sandhu writes.

The extra yield 30-year bunds offer over five-year notes is at 127 basis points, near 115 basis points hit earlier this month, and is 42 basis points below last year’s steepest level.

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It’s now at the 50 percent retracement of flattening move from summer 2014 oil slide.

The bull flattening of the curve may extend further unless the ECB cuts the deposit rate by more than 10 basis points in March or removes the floor on the yield for quantitative easing purchases.

The curve had flattened aggressively from the second half of 2014 to the first quarter of 2015 amid heightened deflationary fears.

Euro inflation curve pricing shows investors pessimism that ECB’s target of close to 2 percent will be met even in 20 years, with option premiums to protect against inflation near lowest level since Bloomberg started compiling the data in 2009.

Generic two-year bond yield is at minus 0.52 percent, well below the ECB deposit rate of minus 0.30 percent, making the bonds ineligible for QE purchases.

Renewed U.S. recessionary concerns, slide in oil prices and fallout of China slowdown have fueled flight-to-quality demand for longer maturity bunds.

The distortionary effects of ECB’s easing policy on the curve will be further amplified if the central bank changes its purchase rules.

Scenarios

An aggressive deposit rate cut will steepen the curve but such a move isn’t an obvious choice for ECB President Mario Draghi.

The recent widening of European banking credit spreads, which induced a peripheral blowout, highlighted that banks’ profitability could come under increased pressure on continued deposit rate cuts.

Further QE purchases alone will have a flattening bias in the 5s30s curve, without changes to purchasing rules.

Potential for longer-end steepening, e.g. 10s30s, as inflation markets may perceive the move as positive via the credit channel.

Increasing QE too aggressively may give rise to scarcity issues but ECB can counter this by increasing issue limit for purchases from 33 percent.

Removal of the floor yield on purchases would have an immediate steepener impact as ECB will be eligible to buy short-dated bonds they couldn’t before.

Note: Tanvir Sandhu is an cross-asset derivatives market strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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