Europe’s Risky Bonds Tempt Traders as ECB Signals No Taper Yet

(Bloomberg) -- A battle is raging in Europe’s riskiest government-bond markets between fear that central bank support is waning and desire to snap up some of the region’s most lucrative assets.

Nowhere is the tension more evident than in Italy’s sovereign debt, where the longest run of weekly declines for the nation’s 10-year notes since 2018 was followed Friday by the most explosive two-day rally since mid-March.

Spurring the moves is a debate over whether the European Central Bank is going to slow its asset purchases next month as the economy bounces back from the steepest recession in decades. For those willing to bet against it, the latest rise in yields was too good to pass up.

“Volatility will increase now that there are more competing drivers and increasing questions about the ECB’s willingness to buy bonds aggressively,” said Jan von Gerich, chief strategist at Nordea Markets.”

President Christine Lagarde appeared to push back against some of the speculation percolating in the market, playing down the possibility of a major change away from the current stimulus settings when policy makers meet in June.

Her comments knocked the euro, which fell as much as 0.5% against the dollar Friday, retreating from a near five-month high. And it bolstered the case for loading up on Italian debt, which after a selloff this year boasts a yield of over 1%, one of highest in the eurozone.

“The risk of a premature tightening is lower than in the past, and is currently over-estimated by market participants,” Peter Chatwell, Mizuho International Plc’s head of multi-asset strategy, wrote in a note to clients.

Peak Inflation?

He expects the extra spread on 10-year Italian over equivalent German securities will narrow to 80 basis points from around 117 currently. Whether that happens or not rests to a large extent on the inflation outlook.

If the latest bounce in consumer prices is more than just a transitory shock as economies reopen after the pandemic, then the case for more monetary support could unravel, denting demand for riskier peripheral debt in particular.

Five-year, five-year inflation swaps, a gauge of expectations for rising prices over the next decade, shows investors pricing in a rate of around 1.6%, close to the highest level since 2018.

For bond bulls though, that may be the peak. Mizuho and Rabobank International are among banks saying that June is too soon for the ECB to start slowing purchases under the pandemic program, citing a regional economic recovery that is only just getting underway.

Meanwhile, NatWest Markets argues the ECB will still be supportive enough to help insulate the nation from any extended selloff, while faster economic growth will also support the market.

“The key thing for Italy is that the ECB -- and central banks in general -- is that they will be the last to believe and react to the inflation story,” said Imogen Bachra, a European rates strategist at NatWest. “The recovery story should be a bigger positive for Italy than the withdrawal of ECB support.”

Next Week

• European government bond supply is set to moderate to about 16 billion euros ($19.4 billion) from 32 billion euros this week, according to Commerzbank, with auctions in Germany, the Netherlands and Italy
• The U.K. is expected to sell linkers while four Bank of England officials will answer legislators’ questions on Monday
• A range of speeches from ECB officials, including Villeroy, Guindos and Lane with dominate the agenda
• On the data front, attention will turn to French and German GDP and inflation readings, as well as German IFO expectations

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