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FUNDAMENTAL ANALYSIS

Interest Rate Strategy

Interest rates, strategy, government bonds, bond yields, bond strategy, bond analysis, recommendations, bond investment, yields

15 May 2015

The recent sell-off of European and US government bond market was surprising because of intensity and speed, not because of the size of the adjustment. The 10-year Bund yield rose by 50 bps last month, of which 30pb from last FOMC, the euro swap rate rose 45pb and this move was accompanied by a steepening of the curve with the 2/10Y Bund climbing to 80bp from a 34bp low and 10/30Y Bund to 57pb spot from lows below 40pb.

As we have written in the past1 the heavy flattening of the yield curves resulting from the QE had pushed forward rates on long-term horizons of extremely low levels, that were not consistent with a scenario of cyclical recovery and effectiveness of extraordinary measures of monetary policy implemented by the ECB. Looking at the dynamics of the 10Y1M euro forward swap rates, which we use as a proxy of the neutral policy rate (chart below) we note that the recent sell-off has led to a very limited correction not only on the euro curves but also on the USD ones: the EUR fwd swap rate rose from lows below 1% to 1.8% spot compared with a 2010-2014 average of 3.3%, while the USD fwd rate rose from lows of 2.6% up to 3.25% compared to an average of 4% from 2010 to 2014. This drop of the long-term equilibrium rate seems consistent with the theory of "secular stagnation", which advocates an irreversible reduction of potential growth. The latest FOMC projections (March ’15) indicate a long-term equilibrium level of Fed funds of 3.6% on average, not too far from the current level of 10Y1M forward rate.

 

Interest rates, strategy, government bonds, bond yields, bond strategy, bond analysis, recommendations, bond investment, yieldsSource: Bloomberg, Intesa Sanpaolo

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