European Fixed Income Markets

Risk assets and EGB spreads decouple. Equity markets hit fresh highs this week, while the iTraxx Senior Financial index touched a 5-month low. In this context, safe havens underperformed, with 10yr Bund yields rising to the highest level in 12 months (i.e. 0.50%).

The risk-on mood, however, did not extend to EGB spreads, which have remained under widening pressure (new issue concessions notwithstanding). This is not just political risk premia creeping into markets such as France (where underperformance versus Germany is now also showing up in equities), or Italy (where the Court ruling has paved the way for possible snap elections in late Q2/Q3). Also Irish and Belgian spreads over Bunds have remained on a widening trajectory, suggesting that ECB tapering fears may also be in play.

That said, 10yr Bono/Bund spreads have continued to buck the widening trend (Figure 1), and accordingly 10yr SPGBs now look more than 30bp overvalued on a RV basis according to our fair value model. We suspect that at some point, either risk assets will struggle to make new highs or EGB spreads will start to re-tighten. We deem the former slightly more likely, although we do see value in EGBs which are less exposed to political risk (for example Ireland). Alternatively, we would suggest to go long Ireland versus Austria.

In money markets, meanwhile, we find the 1-month Eonia forward for mid-2018 having risen further, to 8bp above the current fixing – even more at odds with the ECB’s forward guidance that policy rates won’t go up until “well after the horizon of the net asset purchases”. EGB supply to remain above €20bn (Figure 20). On Monday, the Tesoro will launch a new 10yr BTPS (€3.5-4bn) as well re-open the BTPS 0.35 11/21 and CCTS 2/24. The new 10yr is trading 2-3bp cheap on the low-coupon curve in the grey market, and as highlighted above, has lost significant ground versus Spain, which should support demand at the auction. The CCTs 2/24 trades a tad rich relative to the low-coupon BTP curve, but at a juicy 19bp pick-up to the adjacent CCTS 7/23. Elsewhere, Germany will issue a new 5yr OBL, while markets are still awaiting a syndicated deal from Finland (10yr or 30yr). For a complete overview of next week’s supply and rating reviews please see pages 5 and 6.