European Fixed Income
The sell-off in Bunds after Mario Draghi’s speech in Sintra felt like a distant memory this week, as 10yr yields dropped back well below 0.50%, the top end of the range that prevailed in the first half of this year. The catalyst of yesterday’s downtick was the less hawkish tone from the BoE, with the news on the Russia probe in the US further supporting the bullish momentum.
This didn’t prevent 10yr BTP/Bund spreads from hitting fresh year-to-date date lows this week, suggesting carry trades remain in favour. We also saw Bono/Bund spreads holding near their post-QE lows, despite the growing clash between the Spanish central and Catalan government on the latter’s desire to hold a referendum on independence on October 1.

We still believe that peripheral spreads, Italian ones in particular, are vulnerable to the upcoming ECB QE taper. Indeed, our fair value estimate for 10yr Bono/Bund spreads, which is based off relative growth and fiscal differences amongst others, suggests that the tightening impact of QE is still around 50bp at the moment. While we do not think this will fully disappear after the taper announcement, much will depend on how long the tapering will take. In our view the ECB will be keen to avoid a scenario where investors immediately extrapolate the end of the net asset purchases. To credibly signal that QE could be extended further, however, taking into account the scarcity of eligible debt, the ECB would likely have to tweak the modalities of the PSPP, e.g. increase the issue share limit for non-CAC bonds. All in all, the summer calm in peripheral bond markets may well persist until Draghi’s speech at the August 24-26 the Jackson Hole Summit, which takes place two weeks before the September ECB meeting.