Uncertainty and political chaos spread

Core bonds profited from the UK’s decision to leave the EU. It triggered an overall risk-off sentiment and obliged a lot of players to reposition as the market anticipated a “Remain” victory. The other side of the coin were heavy losses on equity markets, sterling, corporate bonds and peripheral bonds. Beside core bonds also gold and the yen profited from the pro-Brexit decision. The BoE, Fed and ECB stated that they closely monitor financial markets and are ready to deliver liquidity, if needed, which might have calmed markets somewhat. The Swiss central bank confirmed FX interventions to stem the appreciation of the franc and the Japanese Minister of Finance called for coordinated G7 action. In a number of markets, the initial sharp moves met some profit taking during the day, for instance in the safe haven bonds. However, the daily changes remained substantial. The German yield curve bull flattened with yields 8.1 (2-yr), 9.5 (5-yr) 14.1 (10-yr) and even 23.4 bps (30-yr) lower. All maturities set new lows. The euro swap curve flattened too, with rate declining between 4.3 and 17.2 bps. In the US curve, the shape didn’t change so much with the belly outperforming and yields down between 14.5 bps (30-yr) and 19.6 bps (10-yr). The market priced out almost all rate hikes. The difference between the 2-yr Treasury yield and the IOER rate is only 10 bps and while the US 2-yr swap rate is only 22 bps higher than the IOER rate, suggesting that rate cuts are not completely excluded further down the road. The UK Gilt market showed similar large declines with yields 25 bps to 32 bps lower.

On intra-EMU bond markets, peripheral bonds were heavily sold, as were peripheral equities which underperformed core European equities. Peripheral 10-yr yield spreads widened 30 bps (Italy/Spain), 41 bps (Portugal) and 101 bps (Greece) respectively. Semi-core (Belgium/France) spreads widened 7 bps while non-core German spreads widened 5 bps.

UK politics and Brexit remain the focus

After Cameron’s resignation on Friday, also the UK EU Commissioner resigned and the infighting in the Conservative party started with the New leadership at stake. It’s unclear whether new elections will be needed to give the new (Brexit) PM enough legitimacy, as the majority of the current Conservative parliamentarians were against Brexit. In the UK la bour market, the leadership of Corbyn is questioned after half of its shadow cabinet resigned due to his lack of leadership. Meanwhile the Scottish PM plays with the idea of a second referendum on independence followed by EU entry. Voices in Northern Ireland speak also about a referendum, even if that looks unlikely given the divide between Catholics and protestants. From the EU side, there is pressure that the UK notifies its exit immediately, while some British politicians like Johnson say they will take their time. Such a notification is needed to start the exit negotiations. Today, Merkel, Hollande and Renzi sit together to discuss the situation and an EU Summit is scheduled for Tuesday and Wednesday. The ECB’s forum of central bankers starts in Portugal with Draghi and Yellen the main participants. Their comments will interesting given recent events. The eco data won’t have much impact for some time.

Spanish general election: prolonged deadlock?

Spanish PM Rajoy’s Partido Popular emerged again as winner of the Spanish general elections, gaining 33% of the vote (137 seats). The Socialist surprisingly defended their traditional position on the Spanish Left (23%; 85 seats), beating the far-left Podemos (21%; 71 seats). The centrist Ciudadanos party was distant fourth (13%; 32 seats). Like in December, there’s no clear option for a coalition in the 350-seat Spanish parliament.
Rajoy will probably try to assemble a centrist coalition with the Socialists and Ciudadanos, but these potential partners blocked that option in the past months. The political deadlock remains, but the disappointing outcome for Podemos could benefit Spanish bonds.

Risk aversion expected to remain dominant

Overnight, Asian equities trade mixed with China and Japan nevertheless rebounding.
Other risk barometers point in the direction of more risk aversion at the onset of trading. Gold, the Japanese yen and the US Note future extend gains, suggesting a better opening for the Bund as well.

Today’s eco calendar is second tier. The ECB forum in Sintra on central bank speaking could be more interesting with ECB Draghi and Fed chair Yellen making public appearances. In the wake of the Brexit-vote, we expect more volatility and risk aversion cross markets, looking for a new equilibrium. That should keep core bonds underpinned, flattening the curves. The next rate hike by the Fed is now only discounted by mid-2018, with a 10% market implied probability of a rate cut in July. Technically, we expect the US 10-yr yield to test the all-time low (1.38%). On intra-EMU bond markets, we expect some respite and calm to return after the sharp widening of the spreads on Friday and the key resistances reached. Fundamentals weaken, but ECB buying and the search for yield should compensate.