Wednesday, 19 September 2018

Where is the equilibrium for 10-year eurozone yields?

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Shah: It is unlikely that 10-year yields will move beyond the pre-QE levels.

The line of least resistance for the fixed income markets continues to be toward weakness. There remains uncertainty as to where yields will settle and the new equilibrium. What is clear from the price action is that entrenched longs are still choosing to hedge their exposure via futures as opposed to trimming or cutting exposure.

These longs have deep pockets and are not about to throw in the towel on a trade they have entered on progressively during 2014 and are still providing an attractive yield. And by hedging through futures, these longs are able to hedge the P&L against short term movements in the price.

The thing about FI is that getting in at a yield of 4% means that you earn this nominally every year as long as you are willing to keep the investment until maturity. There is no urgency to sell out of eurozone bond holdings especially as:

1) the ECB continues to signal QE will not prematurely end and

2) it’s too early to suggest the fight against low inflation and inflation expectations has been won.

Until there is a significant change in the outlook for the eurozone economy or ECB policy it is unlikely that shorts will be favoured with any conviction. Before we started to really get QE hints from the ECB in December 2014 the 10-year yield on Italy and Spain were trading around 2.35% and 2.15% while 10-year Germany was around 0.85%.

We may have already moved from excessively low yield levels and while it is uncertain where yields will settle it is unlikely that 10-year yields will move beyond the pre-QE levels above. It seems more likely that 10-year yields will settle around the pre-QE levels ahead of the Jan 22 meeting when QE was announced.

For 10-year Bunds this was around 0.47%, for 10-year Italy it was 1.68% and for 10-year Spain it was 1.52%. But before things settle down we are likely to test the Dec 2014 yield highs closer to 0.80% .

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