bonds euro europe QE

This Is One Rally You Probably Shouldn’t Fade (And I’m Not Talking About Stocks)

Holy Schatz! Again.

Last week was all about the Schatz rally.

Indeed record low 2-year German yields present something of a paradox for markets as traders and investors struggle to reconcile a voracious bid for one of the world’s safe-haven assets par excellence with buoyant risk (i.e. record stocks), suppressed vol, and tight credit spreads both in the US and Europe.

With stocks disconnected…


… and credit asleep as iTraxx Main trades inside of swap spreads for the first time since 2008…


… here’s a rundown of the Street’s take on what is surely to be a hot topic going forward even if French election risk recedes.

Via Bloomberg

Schatz rally being driven by increased ECB QE purchases, demand from other central banks as a result of currency intervention, haven buying and re-denomination risk, strategists say.
  • JPMorgan doesn’t want to fade bund rally but adds 10s30s steepener, Deutsche Bank closes long OAT vs BTP/Bund, now recommends short 3y OAT as cheap election hedge
  • Deutsche Bank (strategists including Francis Yared)
    • French spreads to Germany are impacted not only by French specific risk, but also by German richness, especially in the front-end; more recent spread widening is likely to reflect re-denomination risk, with market pricing around 3-6% chance
      • Outperformance of Germany also due to conservative investors reducing exposure to France, moving into Germany, particularly as Germany is perceived to be a hedge against re-denomination risk
    • Increased pace of intervention by the SNB and with the Czech national bank stating that it will be removing its floor around mid-17, attracts inflows; likely that intervention will favor the front-end of Germany
    • In terms of trades, exit Bund ASW tightener as it reached stop level, close long France vs Italy and Germany; close EUR 1y1y/3y1y steepener, as repricing required unlikely to happen with French election risk
      • Rotate short Italy 10Y into the 5Y sector and add a short France 3Y, to benefit in a convex way from an acceleration of the stresses in France and the pricing of further re-denomination risk
  • Barclays (strategists including Cagdas Aksu)
    • Richening of the front end of the German curve both outright and vs Eonia, related to the increase in risk aversion on rising political risk, which has increased haven demand for front-end German paper
    • 10y gilt linker breakevens have cheapened sharply since early February, but from rich levels; don’t see enough of a fundamental discount to fair value for this to merit opposition
      • Long-end breakevens look cheap after heavy supply generated concession in the ultra-long end, recommend I/L 2040-2058 steepeners
  • Citigroup (strategists including Harvinder Sian)
    • Schatz yields to rally further, to -1% and beyond, Bunds to follow and swap spreads to richen even as ECB QE flow to see significant buying in the front-end German curve over the next year: MORE
    • Volatility in OAT/bund spread nowhere near as notable as during 2011-2012; France has disconnected from iTraxx, though there no evidence of yield curve inversion
      • High coupon bonds have underperformed their peers; upcoming net supply very supportive France in April (around -EU32b), which is around the time of the first round of the election
      • Ongoing political uncertainty and headline risks are likely to continue to weigh on the market tone and keep spreads around the 75bp context for now; fundamentally like France but remain cautious till April
    • Recommend EUR 3y10y/3y30y vol spread, given the spread is roughly flat, which is attractive; long position in the vol spread benefits from highly positive rolldown and could be construed as hedge vs risks of renewed flare-up of the sovereign crisis in the euro area
  • Morgan Stanley (strategists including Anton Heese)
    • Bond Market Indicators are neutral on Bunds and gilts, and bearish on USTs and JGBs; Bund signal became more bearish following upside economic growth surprises reported last week, more than offsetting the more positive momentum indicator
    • Main positioning recommendations remain 5s30s steepeners in euro (which has a bearish bias) and 2s5s flatteners in gilts (which have a bullish bias)
    • Revise 2017 Bund yield forecasts lower, expect the 2y Schatz to end the year around -70bp, 60bp lower than forecast in the 2017 outlook; also shift 10y Bund forecast 20bp lower to 70bps
    • Price action in EGB markets in response to the upcoming elections has “been strange”, given it hasn’t been mirrored in other markets
      • Credit spreads have not widened to the same extent as sovereign spreads, systemic risk indicators remain subdued; suggests that much of the price action in OATs may be driven by positioning issues rather than broad-based electoral concern
  • JPMorgan (strategists including Fabio Bassi)
    • Fluidity in French politics continues to offset the strong euro-area economic momentum, putting downward pressure on yields
      • OAT-Bund spreads appear expensive relative to likely election scenario, but markets will likely continue to require a risk premium
      • Investors wishing to hedge political risks should consider receiving reds EUR/USD cross-currency basis as alternative to Bund swap spread widener
    • In EGB spreads, position for French political uncertainty via convex or cheap hedges; hold short 10Y France vs Germany, hold shorts in DSL 02/2042–Bund 07/2042 as the spread at 9bps is the tightest across the curve
      • In high-coupon/low-coupon trades, hold a long in the low-coupon OAT 05/2036 vs high-coupon 10/2038, the trade has started to work but still has decent potential
    • Don’t recommend fading the Bund rally yet, but re-enter 10s30s Bund steepeners; stay long in 2Y Schatz but shift stop to -90bps
    • Cross market, find buying Eurodollar midcurve puts vs Euribor puts attractive way to position for divergence in monetary policy between the Fed and the ECB
      • Buy 98.125 June 2017 1Y Eurodollar mid-curve put versus selling 100.25 June. 2017 1Y Euribor midcurve put at zero cost
  • BofAML (strategists including Sphia Salim)
    • Schatz yields reached their lowest-ever level last week, breaching -90bps; flight to quality, QE buying, and shift in central bank purchases appear to explain most of week’s move
      • In addition, the recent EUR depreciation puts pressure on several non-euro central banks to intervene in the FX market (buying EUR), implying added purchases in short-dated German bonds
    • In terms of QE implementation, if the Bundesbank is concerned about the low level of yields in the front- end, it could temporarily shift its purchases back to the 5y+ sector
      • ECB has the potential to do so for the next 2 months before running out of bonds to buy in that sector, beyond new issues
      • Alternatively could temporarily reduce its buying of German bonds all together, implying that the split of PSPP purchases across countries diverges temporarily from capital keys


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