It now seems to us that the risk to this forecast is to the upside; not because market yields have risen per se, but because what the rise represents is a renewed market focus on the fundamentals instead of on the “flow argument” (of ECB buying versus net issuance), which we consider to be deeply flawed.
We do not recommend chasing Bund yields higher from here. Indeed, some of the metrics which we noted were pointing to richness two months ago are now indicating that Bunds are exhibiting significantly more value than they were. We believe that a pull-back in what is now a bear trend is likely before yields reach 1.20-1.30 as Bunds would look cheap at those levels, at least in the short term.
Use corrections to reduce duration again
However, as we also think the trend will eventually extend further, we would not look to fade this move even at 30bp higher than the current level. Instead, we would look to use pull-backs to reduce duration again. Were such a correction to take place from here, we would look for 0.60-0.70% in order to do this.
We stick to our targets, but a bear trend from here might be “The Big One”
We continue to target 0.90% and 2.00% for 10-year Bunds at the ends of 2015 and 2016 respectively, though the risks appear to those forecasts appear skewed to the upside. If nominal growth forecasts are correct, it is even possible that yields could move to levels at which even the 25-year old secular bull trend might seem threatened.
EGB 5yr/10yr curves: outlook for core & peripherals
We recommend fading the recent steepening in 5yr/10yr Italy and Spain. The magnitude of the recent bear-steepening has overshot compared to the move in 10yr yields. Were the situation in Greece to escalate significantly it would likely reverse the recent dynamic of bear-steepening to bear-flattening. Our preferred way to express flatteners in peripheral markets is against steepeners in core markets. We see value in Italy 5yr/10yr vs France in this way.