If you really know markets, then you know that last week’s biggest story was plunging German 2-year yields.
To the uninitiated that sounds horribly esoteric and worse, terribly boring. But it’s not. What you’re seeing is a remarkable divergence between one of the world’s safe haven assets par excellence and risk assets. The disconnect is readily apparent in the following chart:
How can risk (stocks) be buoyant amid such a massive Schatz bid?
One explanation, as SocGen wrote on Friday, is that “the moves reflect investors paring bearish bond trades while sticking to bullish risk views.”
I’m not entirely sure that’s a healthy way to go about things.
As you think about this apparent contradiction, consider that it has real implications for US assets. More specifically, what are we to make of the reflation narrative if Treasurys catch the same bid Schatz are catching even as economic data paints a rosy picture and stocks suggest things are better than ever?
Great question. Indeed, it may be the question going forward. Here with some further color on this is Citi.
As we get closer to elections in continental Europe, European bond markets are increasingly pricing in the optionality of adverse outcomes. This has resulted in German 2y yields hitting their lowest levels ever this month (-94bp at the time of writing) amid a steady leak wider in peripheral spreads. As our European colleagues explain, the rally in 2y German rates is likely to continue, taking yields to below -1%, irrespective of what happens in the elections, as the primary driver here is the ongoing ECB QE program, which has a capital key constraint, capping yields on bunds by design.
What does this mean for USTs? The inference from our perspective is bullish as the stock of safe haven sovereign debt has shrunk dramatically over the last few years with QE dynamics in Europe (where French OATs are no longer considered part of the safe “core” due to redenomination uncertainties). Net supply in bunds this year is -143bn due to the ECB purchases. Likewise, BoJ’s purchases have taken a sizeable chunk out of the JGB market. This leaves US Treasuries as the primary source of core sovereign debt for investors (other markets such as Canada and Australia are smaller). If the grind lower in European rates continues due to political uncertainty given that the first round of the election in France is still quite some time away (April 23), and the consequent demand for safe assets is maintained, investors will continue to pivot towards US Treasuries.
Another big worry for markets, and a potential driver for lower yields, is the potential for the new administration to take an adversarial stand on issues such as tax reform, immigration and deregulation. We note that the sharp selloff in rates and the accompanying sharp rally in equities a few hours after the election result in November, was the result of a conciliatory speech by President elect Trump. On the other hand, if the path forward politically is more likely to be confrontational, with both parties digging in their heels, it is quite possible that there might be minimal progress this year on the key issue that matters to investors – fiscal reform. In that scenario, we could very well see yields continue to move lower, and we see the curve moving steeper in that scenario (the Fed doesn’t have to trade off monetary tightening for fiscal easing). We are also growing less optimistic on the potential for domestic expectations – consumer confidence in particular, to stay elevated. Our thesis for 2017 is that rates will sell off into peak optimism and then gradually taper off. While we tentatively marked the second quarter as a period of peak optimism, we may very well be already past that point now.