What effects might the European stimulus agreement bring on FX and bonds

Something not always looked at in the FX markets is the impact on bonds and yields and how it may influence the overall economy of the nation behind the offered yields. With all of the talk on the European Unions coronavirus recovery plans and the European Central banks Offerings for stimulus, I thought it may be a good time to discuss it.

Today my focus is as above, but with more emphasis on the widening spread between German bunds and the Italian yields. Earlier today I was asked if I thought that this space between them would widen. Spreads between the Italian 10-year government bonds (BTPs) and German 10-year Bunds, have an interesting relationship. between European bonds they are the most closely followed, the German side is often thought of to be the risk adverse option, considered to have a level of stability by comparison to the remainder of European bond markets. And the Italian BTPs are on the riskier end of the spectrum offering a rewarding premium for the investors with a higher risk tolerance.

Shortly after the pandemic began, we saw an influx of European Government debt as investors sort safe havens to protect returns and capital. When we see monetary stimulus offered by central banks in this instance the ECB, there is usually some rapid movements or changes to the valuations and yields that these bonds offer, purely because when we hear the words quantitative easing, historically it has meant the purchase of government backed debt or simply bonds.

When there is news of additional stimulus measures like we are seeing with the Pandemic Emergency Purchase Programme currently, then bond yields tend to rise as investors try to make more room for and sell any held outstanding bonds. Conversely when the tapering of stimulus occurs a collapse in yields often follow pretty quickly after.

When it comes to the Italian vs the German government backed debt, right now with the looming cash injection investors are favouring the the Italian BTPs, purely because the stimulus should theoretically help stabilise the yields for 10-year offerings. This provides a tidy scenario for the bond investor, government backed safety with a high return premium.

The thing to keep an eye on in these matters it also on the differences between the 2 and 10 year yield spread, a steepening curve implies that there are expectations for greater economic activity, like the kind usually offered by an economic cash injection conducted through monetary policy measures.

Interestingly from a technical perspective the fluctuations in yields when stimulus occur often present with common patterns usually seen in other markets.

Italian 10 Year vs German 10 Year Spread

Each of the arrows highlight a very obvious double top or bottom pattern in the chart above, at each occurrence some level of monetary policy was adjusted. The ones closer to the Global Financial Crisis offering direct stimulus and at the opposite ending reflecting cash rate changes by the ECB.

Naturally there is more to it than just stimulus and monetary controls but the relationship should certainly be noted for in the future.

So looking at the question I was asked earlier: is the spread going to widen further apart between the Italian and the German Bonds? Considering the current talks over stimulus from the ECB to help with the virus recovery efforts id have to say its plausible. Its not ever a guarantee, but there is enough to speculate that it may.

The real catalyst on developing real conviction would be on how the ECB decides to distribute the funds to each of the 27-euro zone nations. This then raises the next question, what will happen to the Euro? Short answer provided the allocation of funds goes as currently forecast and there are no real major surprises, then its likely already priced into the valuations. However, if significant changes are made to appease some of the more virus ravaged euro economies then we would have to re-access its potential direction at the time.