Politics Vie With Tapering for Biggest 2017 Driver of Euro Bonds

  • Citigroup, RBS see flatter bund curve on QE, political risks
  • JPMorgan, Deutsche Bank expect steepening on ECB tapering

The new year is almost here yet there’s no consensus among analysts on how core European yield curves will evolve in 2017.

Europe’s still-low inflation expectations, rising political risks and the odds of renewed bund scarcity amid debt purchases by the European Central Bank are supporting expectations for lower longer-term yields and flatter curves. On the other hand, slower bond buying by the ECB, the odds of further reduction in such purchases and a potential spillover from improved growth in the U.S. back the argument for steepening.

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The extra yield on German 30-year bonds over five-year securities has jumped to as high as 166 basis points in December, from a 14-month low of 86 basis points at the end of July, according to data compiled by Bloomberg. The median estimates in Bloomberg surveys for two- and 10-year German yields suggest a lack of direction for the spread, with the difference between the two projected to be little changed from now at the end of next year.

Below is a compilation of strategists’ views on the key risks and trading opportunities in European rates markets in 2017:

Citigroup Inc. (strategists including Harvinder Sian)
* Look for steeper peripheral spread curves fueled by shifting PSPP demand, return of long-dated bond supply and political risks/ratings
* Recommend 10s-30s Italy steepeners vs Germany
* Low core HICP looks embedded as German wage deals reference inflation compensation near 1 percent; bund scarcity and “low-flation” works toward lower yields with the German curve flattening on a repeat reach for yield
* Recommend German 10s-30s flatteners

Deutsche Bank AG (strategists including Abhishek Singhania)
* Expect 10-year bund yields at about 1 percent by end-2017, with ECB likely to indicate a further cut in asset purchases next year as inflation outlook improves
* The reduction in the pace of the ECB’s quantitative easing to 60 billion euros ($66 billion) a month starting April 2017 and any further tapering should have a greater impact on semi-core and peripheral euro-area debt rather than core bonds
* Prefer holding a short position in EUR rates expressed via 50 percent short in France, 50 percent in Spain
* Technical changes to PSPP to result in less long-end buying, steeper curves and tighter long-end ASW
* This combined with rising issuance in the Netherlands, suggests DSL 10s-30s steepener; also recommend Buxl ASW tighteners

Bank of America Merrill Lynch (strategists including Ralf Preusser)
* The euro area requires further policy accommodation and is vulnerable to waning fiscal support and tighter monetary conditions, while deflation risks have not been banished
* It makes little sense for EUR rates to have followed USD rates higher in the front-end of the curve; as a result, prefer being long EUR 2y1y vs USD, receiving 5y on 2s5s10s vs USD, and selling 3m5y OTM payers
* Recent ECB decision seen weighing further on the long-end, expect five-year to outperform as curves steepen

Morgan Stanley (strategists including Anton Heese)
* Investors should underweight bunds and JGBs, overweight U.K. gilts and adopt a neutral stance toward U.S. Treasuries
* The improving inflation outlook should mean ECB starts to guide the market toward its intention to taper asset purchases
* Recommend 2s10s steepeners in Germany over the first six months of 2017
* In the U.K., expect the gilt market to outperform vs U.S. Treasuries and bunds as Brexit uncertainty weighs on the economy, keeps the MPC accommodative despite rising inflation

JPMorgan Chase & Co. (strategists including Fabio Bassi)
* Forecasts higher interest rates and steeper German curve, expects widening trend in euro-area government bond spreads to eventually resume as ECB tapering begins; hold end-2017 targets at 180 basis points for 10y Italy-Germany and 45 basis points for similar-maturity France-Germany
* Higher long-term rates are justified by ECB stimulus withdrawal in 2017, international spillovers and heavy issuance in maturities of over 10 years
* Receive greens Eonia outright, also favor bullish trades via option structures on June 17 greens 2y midcurve
* Initiate carry-efficient steepener with long leg anchored below 3y and weighted bear steepeners
* Position via cross-market payers on reds for USD rates underperformance versus EUR counterparts
* Expect 10y gilt yields to rise to 1.65 percent by the second quarter of 2017, predominantly driven by an increase in Brexit-related uncertainty risk premiums; medium-term steepening bias on the 10s30s gilt curve

RBS (strategists including Giles Gale)
* Positive about bunds in 2017 and see no risk of fiscal slippage, while QE and political risks should help keep high-quality duration in demand; look for lower yields and flatter curve
* As French elections approach, expect France bond underperformance against Belgium; spreads to widen and the curve to steepen relative to the German counterpart
* Spain should grow strongly again in 2017, consolidating as new ‘semi-core’; French presidential elections are a risk in the first quarter as supply picks up seasonally; also expect bank selling throughout the year

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