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Article / 19 April 2017 at 10:00 GMT

Weekly Bond Update: Low yields reflect French nerves — #SaxoStrats

Fixed Income trader / Saxo Bank
Denmark
  • The run-off structure of the French election creates a two-tiered event risk
  • Markets will react to first round next week, with the final outcome two weeks away
  • The GDP growth scenario hardly justifies current ECB policy accommodation
  • 'We are confident the ECB will realise this once the dust settles'
By Michael Boye

Back in February, just as when everyone had convinced themselves that the days of free money were finally going to end for the Eurozone, the German 10-year yield dropped remarkably from the highest level in more than a year to reach a new 2017 low at 0.18%. 

This move made little sense to us, and eventually others, as we pointed to the renewed economic optimism across the Eurozone as well as the widespread feeling that the European Central Bank's decision to taper QE purchases back in December was the warning sign of more to come. 

Sure enough, yields would soon enough spike back up to reach a new high for the year at 0.51% fuelled by speculation that the ECB could soon hike the its deposit rate even though QE purchases have been fully tapered.

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 If Socialist candidate Jean-Luc Mélenchon fares better than centrist Emmanuel Macron in the first round of the election, then France faces a stark left or right choice on May 7. 
Photo: Shutterstock

This deposit rate is the rate at which the ECB pays (charges, really, as it's been negative since mid-2014) private banks for deposits and which has been the subject of intense criticism, as it has pushed government and corporate yields to sub-zero territory as well as weighing heavily on bank earnings. 

So as yields finally rose, reason prevailed – or so we thought.

Rollercoaster ride this year: the 10-year German government yield
Germany
 















Source: Bloomberg

By now, benchmark government yields in the Eurozone are back to – or have passed – the lowest levels for the year. To be fair, though, since then the ECB has soundly backed down on its tightening ambitions, warning market participants against overestimating the pace of policy tightening. 

But there seems to be more behind the move, and that could very well be in the presence of a very familiar foe to European markets this year, as political uncertainty looks set to claim centre-stage once again.

This weekend will see the results of the long-awaited first round of French voting, where we will learn which two candidates will square off in the final vote to become France's next president.

To support investor concerns, as the election draws closer, margins between the front-runners seem to be narrowing. Long time leader and investor favorite Emmanuel Macron still looks to be ahead, albeit by only a few percentage points in front of the dreaded far right candidate Marine Le Pen. 

More importantly, in second round polling Macron remains a clear favorite against Le Pen, but at the moment the concern is that if he loses out to Socialist candidate Jean-Luc Mélenchon, then all bets could be off going into second round of voting on May 7. 

Of course, all of this presupposes that you can even trust the polling – surely "Bremain" and Hillary Clinton supporters would be wary of opinion polls!

What is different though, is that given the run-off election structure, for markets it's a two-tiered event risk, which will see investors first reacting to initial results next week, but knowing full well that the final score won't be known until a full two weeks later.

Polling gap narrows, spread between French and German government bonds widens
France
 















Source: Bloomberg

Investors are taking their precautions, as reflected in the pricing of benchmark Eurozone government yields. However, once the dust has settled, we remain confident that the ECB has to realise that the current economic growth scenario hardly justifies the current level of policy accommodation. 

The tapering of QE bond purchases should eventually dampen the demand for government bonds, and in fact, evidence suggests that it has already started. As mentioned, the ECB has already tapered its total monthly bond purchases from €80 billion to €60bn since the beginning of April, but it has said nothing as to whether it would taper equally across asset classes. 

The central bank does, however, publish its purchases of corporate bonds on a weekly basis, and looking at the numbers so far, there has been no let-down in this segment... which means the majority of tapering has impacted government bond markets.

It is early days, and the central bank can change course as it pleases without notice, but this could mean the largest buyer in European government bond markets is about to shrink dramatically.

– Edited by Robert Ryan

Michael Boye is a fixed income trader at Saxo Bank

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