Rates Spark: Risk-off reflexes at work

Over the past month, markets have rapidly adjusted to the realities of post-QE and QT. This is most evident in Bund swap spreads, but similar trends were also seen in the USD/EUR cross-currency basis, which has shared the same pattern as risk-premia into the looming year-end was reassessed. The shared trends suggest that concerns about German credit amid political instability were less influential, though they likely contributed to the overall movement.

Tuesday’s market reaction to headlines pointing to an escalation in the Ukraine conflict showed that the risk-off reflexes are still working. Bunds were the main recipient of safe-haven flows, outperforming other European government bonds with the 10y initially outperforming versus swaps by almost 4bp. The 10Y yield still sits slightly above swaps and time will tell how lasting the move will be or whether it is seen as an opportunity to jump back on the Bund underperformance trade. So far, the spread performance has been more resilient than the immediate reaction to headlines. However, recent history has shown that Bunds have had a weaker and shorter-lived response to risk-off events, such as the French election turmoil.

We still think that the levels broadly around 5bp above swaps could mark an equilibrium around which 10y Bund spreads evolve with risk-off episodes and supply as well as political turmoil continuing to add volatility. Recall that the equivalent spread of around 20bp above OIS was last observed in 2014 ahead of the European Central Bank's QE.