Article / 10 May 2017 at 10:00 GMT

Weekly Bond Update: European credit markets red hot — #SaxoStrats

  • Risk appetite grows despite political risk, public unrest
  • Franco-German bond spread doesn't react to Macron win
  • European Central Bank may be preparing to taper
Markets may have derived some relief from Europhile Emmanuel Macron's win in France, but it had also been priced in since the first round of voting. Photo: Shutterstock

By Michael Boye

During the past year, political risk and public uproar have been major themes in financial markets. Investors have had to cope with Britain's exit from the European Union, the election of a new and (it's safe to say) more unpredictable president in the US, as well as whole series of elections this year in Europe – most recently the French presidential vote.

Despite political uncertainty and public disgust with the political elite both running at historical highs, risk appetite in European financial markets continues to grow and is in some markets as strong as ever.

European high-yield corporate bond spreads narrows to new year low
Source: Bloomberg

When looking at bond markets in general and the European corporate bond market specifically, signs of fear and instability are distinctly scarce (this contrasts nicely with the impressions one receives reading the news). 

Since the first round of the French presidential election the Itraxx Xover index, which tracks the performance of the 75 most liquid European high-yield corporate bond issuers, has contracted by more than 40 basis points to hit a new low for the year at 250 bps (credit spread metric). 

The index hasn't traded this narrow since the all-time low of 219 bps was reached in 2014. Apparently, the political risks that have kept journalists busy all yeat have not seriously deterred investor sentiment. 

"Improving growth, cheap and abundant money and low inflation do provide hugely supportive fundamentals and political risks may have been more noise than reality so far this year." concluded a recent report from credit rating agency Standard & Poors. 

We are also seeing booming primary market activity, where first-quarter new bond issuances reached record levels, 

Sunday's victory for Emmanuel Macron in the second round of the French presidential election didn't upset anyone but Le Pen campaigners, but it failed to move markets by much. Investors, it would appear, had abandoned the "Le Pen fear trade" following the first round results two weeks prior. 

For government bond markets, this meant that the excessive demand and so-called "re-denomination risk premium" that came in response to Le Pen's campaign promise of leaving the euro and that drove German yields to year-low levels, was quickly unwound and benchmark rates for the Eurozone's biggest economy have been headed higher since.

Franco-German government bond spread didn't move on Macron's 2nd-round win
Bond spread
Source: Bloomberg

Reflecting markets' confidence that Macron would win the day, the spread between French and German 10-year government bonds, representing the added risk premium that investors are paid to assume the counterpart risk of the French government over the German government, barely reacted. Down from a panic high of almost 100 bps to 40 bps, however. it remains higher than the "peace-time" historical average of 20-30 bps as investors remain cautious ahead of the June parliamentary elections. These will define Macron's wider political backing and the form of his government.

In the broader view, political risk is slipping into the background again, allowing investors to focus on monetary policy and the next move from the European Central Bank. We have been arguing for while now that the ECB will soon have to react to the European economy's improving fundamentals – i.e., to the reason equity and credit markets are doing so well!  

Following a rather uneventful meeting in April when investors were still worried about the French elections, the June 8 ECB outing is already shaping up to be an interesting one. Here the ECB will have an obvious chance to signal an upcoming policy change that would most likely include further tapering of quantitative easing, but might even involve deposit rate hikes as well.

The next question, then is how will a priced-for-perfection European economy, as well as equity and bond markets, react to the prospect of a new interest rate paradigm?

European Central Bank
European assets are performing well, but they remain on 'easy' setting. Photo: Shutterstock

— Edited by Michael McKenna

Michael Boye is a fixed income trader at Saxo Bank

fxtime fxtime
IMHO haven status Gov't Bonds are affected not just by political events and base rates but as Bank Of America describe as cross asset skew. In times of market stress certainly we see a strong correlation in Gov't Bonds (correlation value typically 0.71 rising to 0.88) but in times of a sanguine marketplace such as the low volatility we currently see correlation to earnings and ROCE become ever more apparent suggesting yields to rise to compete against corporate assets.
fredajerusha fredajerusha
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