Photographer: Alex Kraus/Bloomberg

European Bond Bulls Recharged by ECB Support, Political Calm

Updated on
  • Rally driven by move away from earlier ‘short bias’: Mizuho
  • Receding political risks in Spain, Italy boost peripheral debt

Euro-area bond markets are on a tear at a time when policy makers are looking to wind down stimulus.

What gives?

While many in the market are surprised by the rally in German bunds and peripheral debt since the European Central Bank’s Oct. 26 meeting, analysts say the ECB’s pledge to step up or even extend its bond purchases as well as fading political risks in Spain and Italy have caused investors to turn bullish.

“This is a function of the market capitulating on its short bias,” said Peter Chatwell, head of European rates strategy at Mizuho International. “Investors were positioned bearishly on the expectation ECB tapering would be negative. They didn’t factor in the stock effect of QE or the redemption flow. We’ve got past the worst of the Catalonia fears, and recent developments in Italy -- the electoral reform being one -- point to a de-escalation of political risk.”

Ten-year yields in Germany were little changed at 0.33 percent as of 10:18 a.m. in London, 15 basis points lower from the day before the ECB meeting. Similar rates in Italy fell 29 basis points in the same period to 1.75 percent, while those in Spain slid 14 basis points to 1.51 percent. Portuguese 10-year yields dropped this week below 2 percent for the first time since April 2015.

For Gadfly’s take on the European bond rally, click here.

The bullishness is catching on. Morgan Stanley recommends buying peripheral European debt, while Barclays Plc has ended a recommendation to sell bunds made prior to the ECB decision. Mizuho International Plc sees German 10-year yields falling to 0.20 percent by year-end, a level not seen since April, and has long positions in peripheral euro bonds. HSBC Holdings Plc cut its year-end forecast for bund yields to 0.6 percent from 0.9 percent earlier.

The rally shows investors are adjusting holdings in response to a more supportive environment, after being previously positioned for relatively bearish prospects, according to the Japanese bank.

For now, euro-area bonds are in a sweet spot. While the region’s economic outlook is brightening, markets aren’t pricing in even a 10-basis point interest-rate increase until at least October 2019. Also, the ECB will continue to pump 30 billion euros ($35 billion) per month into markets for at least nine months next year through its asset-purchase program, in addition to reinvestments of about 10 billion euros per month, adding support to bonds.

‘Confident, Comfortable’

“Investors still feel confident and comfortable to continue with sanguine market conditions -- this means that they are ignoring even bearish news,” said Kim Liu, a fixed-income strategist in Amsterdam at ABN Amro Bank NV, which forecasts bund yields at 0.8 percent by end-2018. “We continue to think that these very low yields will not be sustainable but our base scenario is clearly being tested by the market.”

Peripheral euro-area bonds have also drawn strength from fading political risks. Tensions between Spain’s errant Catalonia region and the central government in Madrid have cooled, while in Italy, the passing of an electoral reform has made it less likely the anti-establishment Five Star Movement will enter government.

The “tail-risk of a euro-zone breakup has further diminished,” wrote Morgan Stanley strategists Elaine Lin and Federico Manicardi in a note to clients. That, combined with the ECB’s stimulus extension, “makes us bullish long peripheral versus core and semi-core sovereigns,” they wrote.

— With assistance by Anooja Debnath

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