Time to Get Tactical on European Rates as Returns Set to Dwindle

© Reuters. Time to Get Tactical on European Rates as Returns Set to Dwindle

(Bloomberg) — Investors may have to get more tactical in 2020 given the impressive returns from European government bonds this year could become much harder to achieve.

may well remain in a broad range. Euro-area cyclical indicators have risen off recent lows and if the U.S. and China reach an initial trade deal then yields will likely reprice higher ahead of economic data improving. However, a strong recovery and higher inflation remains elusive, narrowing the room for yields to increase above 0%.

The space for yields to fall will be limited in the case of a stagnating economy. The bar is high for substantial additional ECB easing given divisions within the Governing Council as arguments grow against negative rates. New record-low yields would likely require a significant economic downturn.

  • Net, trading bunds may be more tactical in nature within a broad range, and conditional option structures make sense. Upside yield risk comes from a possible U.S.-China trade deal and capex rebound vs downside risk of escalation. Bunds are looking to end this year not far from fair value (currently 10bps cheap) when modeled against macro fundamentals.
  • Carry is scarce but historically low rates and volatility implies investors will continue to seek value to meet yield goals. Potential of limited returns from capital appreciation and low levels of core yields leaves carry in focus.
  • Peripheral spreads’ strong 2019 performance restricts the room for further tightening and may well depend on lower core yields, but the high carry on offer in a low-return world may be too enticing for investors. Any bouts of widening on profit-taking and seasonally high supply at the start of the year may be bought if political volatility remains contained and with supportive ECB QE vs lack of net supply.
  • The argument against persistently negative yields and the reversal rate debate may gain traction next year. This can be hedged through expressions such as: paying ECB-dated OIS, selling weighted payer spreads or buying Schatz puts. The swaptions market prices only a small probability of the ECB cutting rates further.
  • Re-anchoring of inflation expectations looks out-of-sight, and there is some risk of a policy mistake given diverging views within the ECB Governing Council and new leadership.
  • A situation where inflation remains stuck, the economy is stagnating and ECB stays on hold will support carry trades. The highest roll-down in EUR forward swaps is in the belly between 5y and 10y tenors, although not historically high. Receiving on shorter-tenors may be favored to avoid the risk of bear-steepening, and with the short-end having nearly priced out ECB cuts.
  • NOTE: Tanvir Sandhu is a global fixed income and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice
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