Core bonds are king in horror land

Rates

Global core bonds had another very strong run as panic in riskier markets spread rapidly and might turn into crisis anytime, or did we witness an exhaustion move? We didn’t find a serious trigger to explain the moves. The eco calendar was empty and events were few. Yes, there was some bad news on Greece again, but that shouldn’t cause panic worldwide. Yes, there were rumours about a big German bank running out of cash (going forward) and the NY Fed inflation survey showed slightly declining inflation expectations, albeit at still rather high level. It is more simply general confidence that is flowing away at high speed. The realisation that asset prices are once again out of line with the economic environment that reasonably can be expected in the next few years. Moreover, there is the feeling that central bankers, who were also the loyal servant of markets are out of bullets and ideas. The ECB experiments with negative rates, as if it is doing an innocent chemical experiment somewhere in the backyard during a BBQ. The Fed’s dot plot with 4 rate hikes in 2016 looks comical. In the meantime, political and geopolitical risks are rising. In Europe, migration is fast unravelling the fundament of open frontiers. In the UK, Brexit may well end up with the country leaving the EU. Portugal is reversing its economic policy, Italy has to cope with its banks, Spain has no government and Catalonia is ever closer to independence. Not to mention Greece…

In the US, there is the tail risk that the presidential elections will go between two outsiders with ideas that don’t bode well for the role of the US and stability in the world. The oil war may become another war in the Middle East between Iran and Saudi. Finally, China faces a transition of its economy that few countries have succeeded in the past while EM firms drown in dollar debt. All this occurs in a context where the BIS admits that the regulation of the banking sector has inevitably affected the available liquidity in many markets. Examples are plenty. Corporate credit spreads are rapidly moving higher and so are peripheral spreads. Dollar liquidity is becomes expensive (45 bps between Euribor and US libor). The technical picture of major equity markets is rapidly deteriorating. All these recent movements smell like crisis. ECB Coeuré said that the G‐20 will address the weakness of EM which risk triggering further depreciation of their currencies. Let’s see whether the selling wave of riskier assets like equities, very prominent this morning in Japan, continues.
The Japanese 10‐yr yield fell below zero for the first time ever. Market technically, we might have witnessed an exhaustion move yesterday which could be followed by an uneasy calm for some time to come. Volumes were very high in equity and core bond future markets for a Monday.

In a daily perspective, the German yield curve bull flattened with yields 1.8 bps (2‐yr: ‐0.51% new low) to10 bps (30‐yr: 0.90%) lower. Changes on the US yield curve ranged between ‐5.6 and ‐9.2 bps. Markets only discount another Fed rate hike in 2‐years’ time and further out see the rate at 1.43% in 5‐years’ time. On intra‐EMU bond markets, peripheral yield spreads widened significantly after staying remarkably stable during the volatile start of the year. The Greek spread increased by 69 bps. The Portuguese spread widened by 33 bps and Italian/Spanish spreads added 19/20 bps. Semi‐core spreads added 4‐5 bps.

Today: Risk sentiment on stock markets key

Overnight, most Asian equity markets remain closed (including China). Other indices trade up to 2% lower with Japan significantly underperforming on the back of JPY strength. The Nikkei loses more than 5%. The US Note future continues his march higher, suggesting a stronger opening for the Bund as well.

Today’s eco calendar remains rather unexciting with only US NFIB small business optimism and JOLTS Job openings. Apart from tomorrow’s Yellen testimony and Friday’s retail sales, the calendar isn’t that enticing later this week either. This means that risk sentiment and technical factors will continue drive trading. European equity markets lost another important support level, suggesting more downside (risk aversion, positive core bonds). The S&P 500 is still testing crucial support. The recovery of oil prices remains tough going and no immediate treat for the Bund. So longer term sentiment remains positive for core bonds (also taking into account the technical picture; see below), but both the Bund and the US Note future are heavily overbought, which make them vulnerable for bouts of short term profit taking is risk sentiment improves.

Technically, the German 10‐yr yield fell below final support (0.42%).
Weakness in equity market/oil prices and the dovish turn of global central banks (ECB, BoE, BoJ and Fed) pulled yields lower since the start of the year. The break lower opens the way for a complete retracement towards the all‐time low at 0.05%. The US 10‐yr yield dropped below 1.9%. From a technical point of view, this also suggests more downside towards 1.64%.

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