You can’t always solve structural problems with cyclical tools but the old adage that technicals are all-too often more important than fundamentals rings true in the core European sovereign debt markets.
Take the somewhat unexpected rally in core markets on Friday. According to Reuters data, 10-year French, Austrian and Belgium government bond yields tightened 5.0 to 6.0 basis points on Friday morning, with yields on the Netherlands and Finland falling by 2.0 to 3.0bp.
Dutch 10-year yields are at a new record-low of 1.44%.
Analysts say this rally in core Europe is unlikely to be driven by expectations of an ECB rate cut, as OIS contracts have failed to materially readjust to the prospect of a lower benchmark rate and the front-end of core government bond yields have failed to tighten.
Sell-side analysts reckon that, although the ECB has opened the door to a rate cut, new policy innovations to boost the transmission of credit to SMEs in the periphery, hot on the heels of the Bank of England’s Funding for Lending Scheme, is perhaps a more likely prospect.
As a result, the most likely driver of the rally is the Bank of Japan’s (BoJ) aggressive policy action on Thursday. As Euromoney reported in March, traders were gearing up for a jump in Japanese real money flows into core European government bonds as Japanese investors look to generate real positive returns amid a weakening yen and rising inflation.
The suggestion was also that for some Japanese and other real money Asian investors, Draghi’s “whatever it takes” play made sense through the soft-core of France, in particular, believing Berlin will hold them in so those notes are de facto Germany with a spread.
The good folk at Nomura note this correlation in one of the more insightful reports on Friday (many sell-side research analysts at bulge-bracket firms do seem to be struggling to say anything original this week, after the BoJ action). They state: “The momentous BoJ decision to buy up longer-dated JGBs, in particular, means that Japanese real money might be tempted to look abroad for duration requirements to a greater extent than before.
“The market started to price this in yesterday, with Spanish and Italian sovereign yields falling, but we believe it can go much further based on historical lags. At current prices, our strategists highlight France as the most likely beneficiary.”
Analysts at Credit Suisse, who perhaps lack granular knowledge of Japanese real money flows compared with their Nomura colleagues, refer to the likely hedge fund bid tracking Japanese flows.
“The recent innovations from the BoJ support tightening in core and soft core spreads to Germany,” they state. “Investment from Japan, released by the BoJ’s aggressive new QE programme, should support non-German core countries.
“France in particular is often a favourite of Japanese investors seeking relatively safe yields in Europe – we would expect hedge funds to front-run this position, which should benefit France disproportionately in the short term.”
However, Nomura analysts go one step further. They reckon European banks will also be a net beneficiary of the Bank of Japan monetary adventure but make what might be a surprising conclusion: bond markets have priced in the downside macro risks, just like their equity investor peers, cf. European banks' shares.
| "The European banks remain highly correlated to sovereign markets, thus any further tightening of sovereign spreads could help unwind some of the more than 12% post-Cyprus fall in the SX7E Continental banks index. With French banks among the weakest performers since the Cyprus crisis broke, we still believe that they could be the biggest beneficiaries of any improvement in sentiment. The key risk to this view is macro, with the sharp deterioration in PMIs in France relative to the eurozone, and even relative to Spain and Italy a good illustration. While this is a risk to watch, our fixed income strategists conclude that it is priced in to the debt markets, while the low valuation of French banks leads us to a similar conclusion in the equity markets." |
In any case, this cyclical bid (or structural, if you believe the market monetarists) for French government bonds is depressing Berlin’s much-favoured market mechanism for policy reform: the bond vigilante. The rally is clearly not a vote of confidence in the economic fundamentals in France, in particular.
Take it away Société Générale, you party-poopers. From its "France needs a new growth model" report:
| "The economic backdrop is weak and bold reforms would probably have a negative impact on activity in the short run which in turn would affect market sentiment. Therefore, we do not forecast a glut of reforms.!" |
And for the battle-hardened financier, here's the kicker: last week a senior board member of a eurozone bank revealed the brutal Realpolitik in the lack of fiscal transfers for the Cyprus bailout. Asked why was it so important now to take such a hard line on bail-in with a non-systemic country, the banker, who also acted as an adivsor to the troika, said: “Because you cannot keep going back to the well of the German taxpayer when we may still need to do so for Spain and even for France.”