Rates Spark: Nothing breaking means higher 10Y Bund yields

With the Fed and now also the Bank of England behind us, EUR rates will be planning their next move. For 10Y Bund yields, we think the direction is higher, because the current 2.2% seems too low in comparison to the macro backdrop as painted by current data and forecasts. The economy is cooling, but this has always been expected given the tight monetary policy. This doesn’t mean we’re anywhere close to a full-blown recession, although we can imagine markets are still traumatised from the 2008 crisis and euro debt crisis.

The bear steepening of the UST curve is adding to the steepening pressure in Bunds, and we shouldn’t be surprised if more bear steepening were to materialise over the coming months. The front end already seems fairly priced in the eurozone and thus the scope for 2Y yields to go lower is limited. On the other hand, the 10Y yield could drift higher and we target 2.6% by the end of next year. As long as nothing breaks, this will be the path of least resistance. And don’t forget that global financial conditions have already started easing, reducing systemic financial stability risks compared to earlier this year.

The Bank of England was not persuaded by the European Central Bank and Federal Reserve to cut again and decided to hold the policy rate at 5.0%, in line with market expectations. The Committee also kept the pace of quantitative easing steady at £100bn over the next 12 months. Of this amount, £87bn will be coming from maturing Gilts, and thus the active sales component is relatively small. There was some talk that this pace could be increased, but the Committee opted unanimously for a predictable path going forward.

The impact on rates will be minimal from the decision to keep the current pace, which was also the consensus view. Quantitative tightening will continue to play on the term risk premium, but we are likely talking in the range of about 10bp for the 10Y yield over the next year. In terms of liquidity conditions, QT will have less effect because the BoE’s short term liquidity facility (STR) has shown significant uptake of late (£44bn now) which mitigates the risk of QT draining too many reserves from the system.