Europe’s Bruised Bond Markets Signal There’s More Pain in Store

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Europe’s bond markets are sending a signal that the latest selloff may be far from over.

Hedging costs are rising in tandem with bond yields as anxious traders prepare for the rout to get worse. It’s the first time that’s happened since 2016, when the European Central Bank rocked the market by announcing it would begin to scale back its bond-buying program.

Europe’s Bruised Bond Markets Signal There’s More Pain in Store

Today, the prospect of a pickup in consumer prices is the driver. Hefty stimulus in the U.S. and vaccine rollouts in the European Union sent a market proxy of expected inflation to the highest in over two years earlier this month, driving up the yield premium on longer-dated bonds. European debt has bruised holders with a 2% loss so far this year, according to Bloomberg Barclays Indexes, the worst start to the year since 2017.

“Investors are more keen to protect against a rise in rates than a fall, suggesting there is more pain,” said Marco Meijer, a senior G-10 rates strategist at BNP Paribas SA in London. Dealers taking the other side these trades also need insure their positions, creating an even bigger short position. “This could lead to an amplified move,” he added.

Over the past two months, the one-year, ten-year swaption -- a gauge of volatility -- has moved up in tandem with the spread between 10- and 30-year yields, a break from a dynamic that’s seen bond yields and hedging premiums move in opposite directions for much of the past five years.

Reflation Woes

Other forces are at play too. For example, Dutch pension funds don’t need to hedge their long-dated holdings as much as before. This has the effect of removing a consistent buyer from the market, leading to a steeper curve. The narrowing premium between the duration of liabilities and the assets held against them by pension funds and life insurance companies also tends to push up long-dated yields.

There are signs momentum from the reflation trade is also filtering into other corners of the market. The so-called five-, 10- and 30-year swap fly -- a measure of how sensitive the 10-year sector is relative to its peers -- has stopped declining.

“This is consistent with the acceleration in the yield sell-off and increasing rates volatility,” Societe Generale SA strategists led by Adam Kurpiel wrote in a note.

Next Week:

  • Auctions from Germany, Italy, Belgium and Netherlands are expected to raise around 20 billion euros, according to Commerzbank AG
    • France pays almost 17 billion euros ($20.6 billion) in bond redemptions, while negligible coupon payments are payable next week
    • The U.K. holds one auction next week, selling 2 billion pounds of 30-year debt and buying back 4.4 billion pounds of securities across three operations
  • Data releases are thin, with Germany’s Ifo survey for February on Monday and March GfK consumer confidence on Thursday alongside euro-area M3 money supply for January and February confidence numbers
    • U.K. data is centered on Tuesday when December wage figures and unemployment numbers are released
  • ECB President Christine Lagarde gives the keynote speech at a European Parliament event on Monday; chief economist Philip Lane and Luis de Guindos speak at separate events on Thursday while Isabel Schnabel speaks at the European Fiscal Board conference on Friday
    • BOE’s Andy Haldane gives a speech at the central bank’s seminar on the “Changing World of Work” on Wednesday; David Ramsden speaks on bank resolution on Friday
  • Moody’s Investors Service reviews France, EFSF, ESM, Fitch Ratings reviews Ireland and DBRS Ltd. reviews Portugal on Friday

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