Europe Bond Market Doubts Grow Over Recovery From War Rout

Europe’s bonds will struggle to bounce back from a sharp selloff triggered by the war in the Middle East, even if the conflict comes to a swift conclusion, according to market participants.

While bonds have staged intermittent rallies on optimism that hostilities might ease, the sector remains highly volatile. Sovereign debt across Europe fell again Thursday, with scant signs of progress in de-escalating the conflict and fears of a ground invasion by US troops.

While strategists reckon the selloff, particularly in shorter-dated securities, has been overdone, they’re warning that yields may settle at higher levels compared to where they were before the war broke out on Feb. 28.

“There are plenty of reasons to expect bond yields to stay in higher ranges from now on — and possibly re-test the upside,” said Laurence Mutkin, head of EMEA rates strategy at BMO Capital Markets.

He points to a range of factors: inflation and government debt piles that are already high and still rising, yields that remain below historic averages, and the threat that positive carry will collapse if central banks hike and drive up repo rates. Carry is the difference between the yield income and the cost of financing the position via repo markets.

“We find considerable merit in the counter-argument to the consensus view that bonds must be cheap at present levels,” Mutkin said.

Germany’s 10-year yield, considered a haven benchmark for the region, is trading above 3%, about 40 basis points higher this month. The two-year yield — which closely tracks interest-rate expectations — has surged even more, rising nearly 70 basis points to 2.67%. The UK’s gilt market moves are even more significant.

Europe’s bonds have been hit particularly hard because the region is reliant on energy imports, so soaring oil and gas prices will push up inflation. That will dim the appeal of holding bonds, even if the economy starts to slow.

Investors are bracing for the possibility that oil prices remain elevated even after the end of the war. BlackRock Inc. President Rob Kapito said this week that oil may still spike to $150 a barrel even if the conflict ends soon, as it would take time for disrupted supply chains to return to full capacity.

It’s a risk that Candriam’s chief investment officer Nicolas Forest is also aware of.

“We will continue to see a risk premium on the oil price putting pressure on the inflation dynamic,” which is a “major risk for the bond markets,” Forest said in an interview. The firm has reduced duration, market parlance for interest-rate exposure.

Citigroup Inc. strategist Jamie Searle echoes some of those concerns, arguing that “bearish risks are growing.” In addition to the inflation outlook, it’s possible that investors start to demand a greater premium to compensate for fiscal risk given the cost of shielding economies from the energy shock, as well as for more borrowing to fund defense spending.

The US bank has moved its year-end forecast for UK 10-year yields to 4.5% from 4.15% previously. They were trading just above 4.90% on Thursday.

“This reflects a view that the selloff is likely an overshoot, but a stronger rally is now unlikely, not least with fiscal and political uncertainties still hanging over the market as well as the duration and size of the inflation shock,” Searle wrote in a client note.

Soaring volatility has also deterred many investors from dipping a toe back in, despite the higher yields. One-month implied volatility on short-dated UK and euro area rates has climbed to the highest in about three years as the war grinds on.

The price swings have kept MFS Investment Management’s Benoit Anne, head of the market insights group, on the sidelines. Still, he’s “ready to move” on rates with the UK and euro area among the most attractive segments.

“Markets are clearly in over-reaction mode,” he said. “When the dust settles, there’s going to be some attractive opportunities to reestablish long duration positions.”

Source