News ID: 236878
Published: 0945 GMT January 05, 2019

All risks besieging Europe bonds spilling over into 2019

All risks besieging Europe bonds spilling over into 2019

For the European bond investors who survived a bruising 2018, there may be bad news in the year ahead.

Higher government spending and political uncertainty threaten rising debt yields in Italy and France, which could spill over elsewhere. Markets don’t expect the European Central Bank to raise interest rates given slowing growth and trade risks, making a sell-off in Germany’s haven bunds look unlikely, Bloomberg wrote.


Mixed fortunes


“The ECB’s exit plan will be put to the test, at a time when the Fed is done after the US curve inverts, Britain barely averts a hard Brexit and investors fret how Italy can cope in the monetary union,” wrote Commerzbank AG strategist Christoph Rieger.

“Under most scenarios, bund yields cannot rise.”

Here’s a preview of what to expect from euro-area bonds this year:



2018 10-year yield finish: 0.24 percent

2019 10-year yield forecast: 0.89 percent

Bunds got caught up in a global sell-off in the early part of 2018 as investors were spooked by rising inflation, but that proved short-lived. Despite the ECB capping its bond buying program, signs of an economic slowdown and dovish rhetoric from President Mario Draghi meant that yields eventually finished the year below where they started.

German bonds have been supported by a swathe of risk factors in recent months, ranging from global trade war fears to Italy’s budget battles. Any signs of those fading, or better-than-expected data in the region, or the UK securing a smooth divorce from the European Union could presage higher yields.

“We suggest a long bias initially, looking to reduce duration during spring with a view to lengthen duration again after summer when US yields look set to peak and the ECB delays the first rate hike into next year,” Commerzbank’s Rieger said.



2018 10-year yield finish: 2.74 percent

2019 10-year yield forecast: 3.37 percent

It was one to forget for Italian bond investors, with the securities the worst performing in the euro area. It all stemmed from the country’s election in March, where a populist coalition between the Five Star Movement and the League emerged as the only viable government. They promised to boost spending and cut taxes, spooking investors and putting them in conflict with the European Union.

Italy may have avoided the EU’s excessive deficit procedure for now, but the threat of recession means it has not gone away entirely. Investors will also be looking for any further signs of strain from within the governing coalition over their diverging spending plans and the growing popularity of the League and its leader Matteo Salvini. A breakdown could see fresh elections in 2019.

 “BTP spreads at 400 basis points or more will likely cause significant stresses in the Italian banking system, and either break the current Five Star Movement-League coalition or cause a course reversal,” wrote Goldman Sachs strategists led by Praveen Korapaty.



2018 10-year yield finish: 0.71 percent

2019 10-year yield forecast: 1.2 percent

French bond yields finished the year more-or-less where they started, but that doesn’t tell the whole story. The spread over Germany finished 2018 at the year’s high as investor favorite Emmanuel Macron was put under heavy strain by ‘yellow vest’ protesters. In response, Macron pledged to boost spending, meaning that France’s deficit next year will be higher than Italy’s.

Alongside heavy borrowing this year, investors will likely pay close attention to Macron’s approval rating, which dropped for a fifth straight month in December and currently languishes at 31 percent, according to a recent poll. That could provide fertile ground for the far-right leader Marine Le Pen to build up her own support.

Bank of America Merrill Lynch recommends investors position for a flatter French yield curve, which has the “the added ‘benefit’ of higher re-denomination risk pricing in the front-end,” wrote strategists Erjon Satko and Sphia Salim in a note to clients.

“This last element would gain importance if demonstrations in France continue, potentially destabilizing Macron’s position ahead of the European elections.”



2018 finish: 1.42 percent

2019 forecast: 1.95 percent

Spain put its Catalan troubles of 2017 firmly in the rear view mirror, defied speculation that contagion would spread from Italy and shrugged off a change in government to finish 2018 with yields 15 basis points lower.

What happens in Italy is still likely to be felt in its Mediterranean peer, albeit not to the extent of the euro-area debt crisis earlier this decade. Goldman estimates that should Italian spreads move into the 350 to 400 basis point range, Spain’s could climb as high as 150 basis points.

“The risk of spillover from Italy is in our view overestimated,” said Arne Lohmann Rasmussen, head of fixed-income research at Danske Bank A/S, which has a long position in Spanish five-year bonds versus France as one of its top trades.

“We are quite positive on the Spanish economy and funding could potentially surprise on the downside.”




Resource: bloomberg
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