Core bonds hold on to gains, despite return of calm

Rates

On Friday, calm returned to markets after Banco Espirito Santo gave more details about its exposure to the ESFG (parent) holding. In this context, it surprised a bit that core global bonds remained well bid following last week’s strong run. German Bunds closed virtually unchanged, after having recouped some early intraday losses. In the US, Treasuries still made some, albeit modest headway with the curve flattening ongoing. Yields were up to 3 bps lower. In late US session, Treasuries gave back part of the gains after Fed governors Plosser and George, albeit two renowned hawks, said they see room for higher rates sooner rather than later. Peripheral yield spread narrowed following a widening in previous sessions. Portugal outperformed (see above) with a 12 bps 10‐yr spread narrowing. Spanish and Italian spreads narrowed 6 bps.

Today, the market calendar is extremely thin with only the May EMU industrial production and a speech of Mr. Draghi at the European parliament on the programme. Regarding the EMU production, last week’s national production data showed a monthly decline in the main four countries. The German decline( 1.8% M/M) was the biggest disappointment, as it should be the main engine to keep the EMU industrial motor running. It was Germany’s third consecutive monthly drop in production. So expectations for the EMU outcome of ‐1.2% M/M and 0.5% Y/Y are downbeat, even if we don’t exclude an even weaker figure. This also means that Q2 production will again be disappointing following a tepid 0.21% Q/Q gain in Q1. At his regular testimony before parliament, Mr. Draghi usually stays close to his remarks at the ECB post meeting press conference. We expect this to be no different this time, in which case the market impact would be negligible. The above mentioned weak production data show though that Mr. Draghi remains under pressure to do more to help the ailing economy and to push inflation higher.

However, Mr. Draghi has an additional handicap. The German policymakers start opposing more vocally a still looser policy stance. FinMin Schaueble said Mario Draghi linked the OMT programme to programmes by the ESM. “No such arrangement exists and it is doubtful that the Bundesbank, which has to approve ESM measures, would back such programmes.” During the weekend, ECB/Bundesbank Weidman said that interest rates are too low for Germany, adding that ECB monetary policy should remain expansive for no longer than absolutely necessary. Low rates on savings and high property prices are a big concern for German policymakers.

EMU bond supply is thin this week with only scheduled auctions in Germany (Wednesday), France and Spain (both Thursday). The German Finanzagentur taps the on the run 10‐yr Bund (1.5% May2024) for €4B. The French treasury taps the on the run 2‐yr BTAN (0.25% Nov2016), off the run 10‐yr OAT (4% Apr2018) and on the run 5‐yr BTAN (0.50% Nov2019) for a combined €7.5‐8.5B. Additionally, they’ll also tap three inflation‐linked bonds for a total amount of €1‐1.5B. The Spanish debt agency auctions the on the run 3‐yr Bono (2.1% Apr2017) and off the run 10‐yr Obligacion (5.85% Jan2022) and 30‐yr Obligacion (5.75% Jul2032). This week’s auctions will be supported by bond redemptions from Austria (€9.5B) and the Netherlands (€12.5B).

Preliminary figures of Slovenia’s early parliamentary elections pointed, as expected, to a clear win for a recently established centre‐left party. Party leader Cerar is expected to be next PM and will try to form a centre‐left coalition. He said that he will stick to plans to reduce Slovenia’s deficit to 3% of GDP next year, but signalled that he will reconsider some of the planned privatisations. We don’t expect a strong reaction on the Slovenian bond market.

Overnight, Asian markets trade positive. Japanese production data were better than expected but had no direct impact on markets. The US Note future has a very marginal downward bias.

Today, the eco calendar is thin with only outdated EMU industrial production data and a Draghi speech (see above). However also the latter is unlikely to impact markets. Ahead of Fed’s Yellen semi‐annual testimony to the Senate Committee tomorrow, US investors might stay side‐lined as well. Some final pre‐positioning could be slightly supportive for bonds, especially at the front end of the curve as a dovish chairwoman is expected. Developments around the Portuguese Banco Espirito Santo are a wildcard for trading. This weekend, the Bank of Portugal ordered the immediate appointment of a new chief executive and other board members (two weeks earlier than expected). Portuguese PM Passos Coelho said that tax payers will not be called on to bear losses of private companies. If no new items pop up, Friday’s action suggest that EMU bond spreads won’t widen again.

Technically, the Bund set a new contract high last week and the German 10‐ yr yield approaches 1.20%. The picture remains bullish for the Bund with return action to the 1.12% all time low in yield terms likely. The environment of weaker eco data, low inflation will keep the hope on ECB QE alive. In this context we cannot be negative of Bunds, even if we think Bunds are too expensive and the distance with the all‐time lows too small to set up additional long positions.