It has been a wild ride in markets over the past week, but there are signs that things are calming down now. As we wrote last week in Strategy: Back to base – strong trends are correcting, 30 April 2015, corrections were going on in all markets that had a strong trend in the first part of 2015: USD, Euro stoxx and German long bonds. Further, the markets that had the strongest rally have seen the biggest correction.
German 30-year bonds take the prize, with the biggest one-week sell-off for at least 20 years. A common feature behind the corrections is that they have all been centred on the QE theme. It is hard to point to a specific trigger in the bond market, although reflation has been mentioned as a theme. However, only 4bp of the 45bp rise in 10-year euro swaps could be explained by higher break-even inflation, so it does not seem as if it has been that important. What is the trigger then? – maybe that valuation had become too stretched and positioning among fast money had become quite long in bonds due to the QE theme. As the market turned, fast money and trend-following accounts closed positions with few buyers on the other side.
The extent of the sell-off is also related to a total drying-out of liquidity as the sell-off gathered pace. This is a by-product of regulation, as market makers today have a much smaller inventory of bonds and as a consequence the buffer for absorbing mismatches in supply and demand has become very small. When the very strong trend in German bonds broke, algo-traders reacted quite mechanically and hit the sell button. But with very limited liquidity the market can move significantly on even small volume.
There has clearly been a clean-out of long positions in the past week and Thursday looked like a capitulation day, where markets sold off massively only to take all the losses back. This is often a signal of a turn in the short term. How about the medium to longer term? With a more clean positioning, fundamentals and the ECB’s continued QE will likely be the important drivers. From a fundamental point of view, we see more upward pressure on US yields as we approach the first Fed hike, which we expect in September. This should have a spill-over to German bonds as well. On the other hand, ECB QE and a decline in the surprise index will work to keep German yields down. Overall, we now expect German 10-year yields on a 3m horizon to move slightly higher, but expect German bonds to outperform US. We don’t expect a new big bear trend, though. For that we need to get closer to ECB exit, which is not going to happen until we are a little into 2016, in our view.
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