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Hottest U.S. Bond Trade of 2017 Is Heading Across the Atlantic

Hottest U.S. Bond Trade of 2017 Is Heading Across the Atlantic

(Bloomberg) -- The flattener fever is spreading to Europe.

Investors are betting that the difference between long- and short-dated yields in European government bonds will narrow this year in an echo of a similar trade on the U.S. curve that was among last year’s most lucrative. Allianz Global Investors is positioned to benefit from a further flattening of the bund curve, while HSBC Holdings Plc is recommending a similar wager in the euro swap market.

Hottest U.S. Bond Trade of 2017 Is Heading Across the Atlantic

The German five- to 30-year spread has already shrunk to the lowest level since 2016, led by increases in the shorter tenor amid rising expectations that the European Central Bank’s first interest-rate increase since 2011 is nearer than previously thought. The trend is abetted by tepid inflation, which is limiting the increase in long-maturity yields.

“The curve is flattening in Europe and so it should be,” said Brian Tomlinson, a money manager in London who helps to oversee nearly half-a-trillion euros ($618 billion) at Allianz Global. “The trend is going to continue and people are going to try and get on board that flattening trend on any steepening.” He favors selling five-year German notes versus both 30-year bunds and 15-year Italian bonds.

ECB Outlook

The German five- to 30-year spread has dropped to 129 basis points from 145 at the end of last year. The shorter tenor climbed 33 basis points this year, turning positive for the first time since 2015, as markets priced in the first increase by the ECB to be delivered in early next year. The longer maturity added only 17 basis points as euro-area inflation slowed.

The similar U.S. slope is at 52 basis points now, after tightening 60 basis points last year in the biggest compression since 2005 in terms of proportion. The curve trade outperformed more vanilla Treasury strategies in 2017, with the benchmark 10-year yield dropping only four basis points in 2017.

While a flattening yield curve stoked recession fears in the U.S., a similar trend in Europe raises no such concern and may even be seen as a sign that the continent is close to weaning itself off years of extraordinary monetary accommodation.

But the strategy doesn’t represent a free lunch. Investors who short the five-year bonds need to surmount the so-called cost of carry, which in this case represents the compensation that needs to be paid to investors who are long the security. Over a one-year holding period from now, investors would need the German five- to 30-year spread to tighten to nearly 100 basis points to avoid losses, according to Bloomberg calculations.

‘Carry’ Concern

“An obvious concern in bearish markets is the cost of carry associated with shorts,” Marc-Henri Thoumin, a strategist at Societe Generale, wrote in a research note. He recommends either a flattening position between bunds maturing in 2039 and 2037, or by implementing the view in five- to 30-year euro swap curve against its U.S. equivalent. That helps avoid “prohibitive” losses from missed carry opportunities, according to the bank.

HSBC sees flattening pressure on the swap curve potentially increasing on euro-area economic data that could spring positive surprises. The Federal Reserve’s rate-hiking cycle last year may provide some guidance to European investors on how to position for expected policy tightening by the ECB, according to the bank.

“History tells us that the market can both underestimate economic downturns and, make the same mistake on the other side, by underestimating the recovery,” HSBC’s global head of fixed income Steven Major wrote in a note last month. “Just as it was the big theme for the U.S. in 2017, euro-zone curve flattening is likely to be one of the main plays of 2018.”

--With assistance from Tanvir Sandhu

To contact the reporter on this story: John Ainger in London at jainger@bloomberg.net.

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Anil Varma

©2018 Bloomberg L.P.