Strategy: The big EUR curve flattening has started

It has been a rocky past month for both the US and the European fixed income market, as 10Y Bund yields have moved 25bp higher and are close to the highest level since the brief spike in yields in July last year. Also, 10Y US treasury yields have moved higher. We have to go back to 2014 to see a similar level, if we disregard the two spikes in yields a year ago.

In our Yield outlook, published last week, we looked at some of the factors behind the recent bond sell-off. We highlighted the global recovery that has recently gained momentum and pushed commodities such as oil and, importantly, inflation expectations higher. The move in break-evens over the past couple of months is quite remarkable.

We also pointed to the re-pricing of ECB and Fed expectations that we have seen recently. The market is now priced for an ECB rate hike in Q1 19 and the March Fed hike is now priced by almost 90%. The repricing of ECB expectations has especially occurred after the recent ECB minutes mentioned that the ‘forward guidance' could be revisited early in the coming year.

We revised higher both our EUR and USD yield and rates forecast, but mainly on a 12M horizon. We have now pencilled in somewhat higher 10Y EUR and USD rates and yields (Germany) on a 12M horizon. We now expect the 10Y EUR swap rate to rise to 1.45% from earlier 1.20% on a 12M horizon. The 10Y USD swap rate is forecast to rise to 2.90% from previously 2.70%. 10Y Bund yields (Germany) and 10Y US Treasury yields are forecast at 1.0% and 2.90% on a 12M horizon, respectively. Short term, the market might have run ahead a bit ahead of the curve and short term we could see some reversal of the recent moves. But we argue that we will have a bearish FI market in 2018.

Curve dynamics – 5Y the focal point in 2018 and flatter 10y30y

We have also seen moves in the European curves over the past couple of months that to a certain degree reflect what we have seen over the past couple of years in the US. First of all, the 5Y point has become the pivotal point on the curve. This is right after the textbook and the normal pattern we see when monetary policy is about to change. On the EUR swap curve, we have seen that the 2y5y curve has steepened and noteworthy that the 5y10y curve has flattened. It is rarely seen that the 2y5y and the 5y10y move in different directions. The result has been that the 2y5y10y ‘butterfly' has moved higher over the past month.

Secondly, we have seen a pronounced flattening of the curve 10y30 in EUR, despite the outright move higher in 10Y EUR rates and the higher inflation expectations reflected in break-even rates. Again, this is different from the pattern seen over the past couple of years.

The flattening of the 10y30y curve is very similar to the pattern we have seen in the US in the past couple of years. In the US, we have since the tapering announcement in 2013 seen a flattening of the USD swap curve 10y30y of 90bp and the curve is now very close to inverting. In our view, the same curve forces are now at play in Europe. It reflects that the 30Y rate of 1.50% in EUR and 2.75% in USD is close to the ‘neutral rate over the cycle' so the long rates are ‘in place'. Hence, the main curve moves are primarily found in the policy sensitive 5y segment and the more inflation expectation sensitive 10Y point.

We believe that looking 6M to 12M ahead that both 5Y and 10Y EUR rates will be somewhat higher. But little is expected to happen in the 30Y segment. Hence, during 2018 we continue to see an extension of the recent flattening of the EUR curve. Both the 5y10y and especially the 10y30y curve are expected to continue the flattening tendency.

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