Developed European Bonds Markets

Market activity was extraordinarily muted yesterday as the US and the UK were still closed. But the ECB resumed its QE purchases after a one-and-a-half-week pause, helping to push the 10yr Bund yield to a near 2-month low of 0.16% (before closing at around 0.19%). A key trend of late has been the rally in real rates towards levels last seen in the run-up to the Bund Tantrum of April 2015. Indeed, the yield on the DBRI 0.1 4/26 briefly reached a 20-month low of -1.20% yesterday, while the yield on the DBRI 4/23 hit a fresh record low of -1.41%. This may be related to the extreme circumstances seen in repo markets (the DBR 8/26 still traded at -6.3%(!) T-N yesterday).

 However, 10yr real swap rates are also close to extreme lows . This reinforces the risk of a near-term correction in our view. EGB supply-wise it will remain quiet this week with only France and Spain coming back to the market. Next week will see more action as the Netherlands, Austria and Italy will hold taps while Germany (and maybe Belgium) will launch a new 10yr. Rating reviews will also resume next week, with DBRS set to review Italy’s A (low) rating on Friday the 13th. A downgrade would imply higher haircuts on collateral in ECB refinancing operations. The busy political risk calendar for 2017 arguably makes for a potentially dangerous cocktail for spreads.

The French presidential elections due for April/May should ensure that 10yr OATs will continue to trade at a minimum (curve-adjusted) 5-10bp pick-up versus 10yr Belgium (temporary new issuance concessions notwithstanding). Moreover, Dutch spreads over Germany also are also likely to come under some widening pressure in the run up to the March elections and new 10yr DDA in February. But if the Dutch/German 10-year spread (currently: 13bp) got out to 25bp that would be a good time to get back in.

10yr BTP/Bund spreads look most vulnerable given the increase in BTP supply and possible snap elections in late 2Q17 in the context of a population that has become increasingly euro-sceptic. However, we would also flag the possibility of another referendum in Catalonia – as again promised by Catalan president Puigdemont recently – weighing on 10yr Bonos, which still look 20bp too rich.