Government yield spreads mostly stable or could decline further in CEE

A reversal of the recent increases, central bank action or good fundamentals could take yield spreads even lower than they are now, but it is important to keep the fiscal balance at a decent level

'How do you see the current government bond yield spreads over 10Y German Bunds in CEE?'

Croatia: In recent months, we saw approx. 20bp spread compression on the long end of the LCY curve (HRK2028 at 2.80%), supporting our story of spread tightening (EUR 10Y - 100bp since Apr-17), courtesy of further improving growth/fiscal fundamentals. Clearly, sensitivity to benchmark developments remains, but it is our view that the aforementioned local drivers and ample HKR liquidity remain supportive of further yield compression in the near future, underpinning our downward yield revision.

Czech Republic: Spreads on 10Y bonds have increased substantially in 2017 and have recorded several peaks over 60 points (currently 68 points). Czech long-term bond yields have increased together with growing inflation and economic growth, and also as a result of the CNB's August hike. However, we do not expect an additional significant increase in the spread for the rest of this year, as we anticipate only limited impacts from the expected CNB hike on the yields of Czech papers.

Hungary: Risk premia of Hungarian sovereign bonds became compressed thanks to Hungary's return to investment grade last year and the abundant liquidity pumped into the market by both developed and local central banks. The sustained compression of the spread over the 10Y Bund could seem puzzling at first, but taking into account the overhaul of the local monetary framework and the changes in the ownership structure of HUF sovereign debt explains the lion share of developments. The MNB holds the next rate setting meeting on Tuesday, with the MPC very likely to introduce additional easing measures – broadly expected by the market. In our view, the only question is the extent of the easing. We would not be too surprised if easing steps reached out along the yield curve, even further than before, which implies further compression of the spread over the Bund.

Poland: The spread vs. Bunds has been holding below but close to 300bp for the last couple of months and we see such a level as fundamentally justified. Currently, the Polish yield curve seems to be more sensitive to global sentiment than to domestic events, while the MPC sees the stability of rates as the most likely scenario for a longer period of time. Moreover, the limited supply of bonds reduces the pressure for yields to rise and the yield curve is likely to follow the development on the core market. Unless political risks for Poland related to the ongoing conflict with the European Commission escalates or global sentiment switches to risk-off mode, we would expect the spread to remain fairly stable in the medium run.

Romania: The spread between 10Y RON government bonds and their German counterpart fell gradually in recent years and is now at around 350bp, compared to levels close to 500bp in 2012. Fiscal consolidation in the past along with the falling inflation rate boosted demand for RON government bonds and non-residents played an important role in this process, significantly increasing their holdings of RON bonds (18% at present, compared with 8% in 2012, all maturities). The inclusion of local bonds in global indices was a game-changer for investor demand at that moment. Most of these things are about to change; the budget deficit is on the rise, inflation is set to increase slowly and investors are paying attention to proposed changes to the fiscal and business environment. Under these circumstances, we see limited room for further spread compression in the next year. However, if this will happen, it will mainly be the result of a strong increase in German yields.

Serbia: Since the beginning of the year, the spread on the Serbian international benchmark USD 2021 bond has compressed by approx. 110bp and now stands at 115bp. Official data for LCY yields is not available, but our calculation shows that there was also a compression of the spread on these securities, now standing at 320bp for RSD 2023. The more favorable fiscal outlook, stable inflation, stronger dinar and still attractive interest rate differential suggest that we could see additional - but milder - compression of the G-spread in the following months.

Slovenia: The robust GDP performance, improving fiscal position and recent rating upgrades pushed yields down, with the EUR 2027 curve declining below the 1% mark (down 15bp vs. the end of 2Q). While favorable local factors should continue to favor spread developments ahead, we see yields gradually moving upwards in the coming quarters, given the expected rise in benchmark yields.

Slovakia: Slovak 10Y yields have been hovering around 0.8% recently, with the spread to German 10Y yields at around 40bp. This is narrower than the 70-77bp spread observed at some points in January and March. Yields on Slovak government bonds could increase somewhat, reflecting the gradual return of inflation, tightening monetary stance of the US Fed and anticipated move towards a less dovish monetary policy of the ECB later on. The ECB should soon (in October) announce its plans regarding QE tapering from 2018 onwards, which is likely to be cautious and gradual. We thus do not expect a strong reaction on the bond market, especially as yield increases are limited by the still loose ECB monetary policy and Slovakia's good fiscal stance (public finances are in check). We expect the 10-year government bond yield to be at around 0.95% in 3Q17, before rising to 1.1% in 4Q17. The spread to Bunds should not be subject to large swings, but should remain within the 35-50 band.

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