Bund yields will turn positive by year-end
European bond yields can only go higher amid the German election, Europe’s increasingly robust economic outlook and stimulus coming from the EU recovery fund.
While a new German government will most likely step away from austerity, the NGEU fund will eliminate some of the imbalances between countries. Stimulus coming from this fund will equalise risk among sovereigns and provoke spreads to compress versus the Bunds.
The improving macroeconomic outlook will also play a crucial part in pushing yields higher as the economy recovers and inflationary pressures will push the ECB to consider a "light taper" by the end of the year or the beginning of the next.
How high can bond yields go?
We are looking at two possible scenarios by the end of the year:
(1) Bund yields stabilising around 0.20%
That will be the case if the reflation trade doesn’t resurface from now until the German elections. In this scenario, yields will trade rangebound on both sides of the Atlantic. However, a government including the Green party will push Bund yields into positive territory anyway, finding resistance around 0.20%.
(2) Bund yields stabilising around 0.6%
That may be the case if we see tapering talks accelerating in the United States during summer, provoking US Treasury yields higher. Thus, we may see Bund yields turning positive before the German election. A government including the Green party will move yields higher, making it likely for 10-year Bund yields to break above their resistance at 0.20%. Therefore, they would enter a fast area where they would find resistance at 0.60% next.
A new paradigm within the European sovereign space: Italian BTPS will benefit from spread compression the most
Positive Bund yields will be a welcome change in the European sovereign space as they have not been positive since May 2019. However, positive bund yields imply that other European sovereign yields will need to move higher, too.
To better understand how the European sovereign market will shape up it's useful to focus our attention on Italy, whose government bonds are offering the highest yields in the euro area at the time of writing.
Since the beginning of the year, the BTP-Bund spread has been trading within 90 and 126 basis points. As Mario Draghi became Prime Minister the spread tightened to the lowest level since 2015. However, as the economy reopened it widened above 100bps.
In the short term, the spread could widen due to divergence in economic recovery and bearish sentiment amid increased volatility in the bond market. However, in the long term we expect it to tighten substantially and to stabilise around 75bps.
We anticipate spread compression to be substantially greater within BTPS than peers due to a stable political environment led by Draghi and disbursements under the NGEU fund, of which Italy will be the biggest beneficiary. The perceived improvement in risk will be met by higher investors' demand, which will find scope to sell Bunds in favour of higher-yielding sovereigns.
Although spread compression will be bullish for BTPS, it will occur as Bund yields will be rising. It means that in the most bearish of the scenarios, we will see 10-year Bund yields rising to 0.6% and Italian BTPS 10-year stabilising around 1.4%. Bund yields will firm up around 0.20% and BTPS yields around 1% in the most bullish scenario.
In conclusion, Italian debt will also suffer losses amid a rise in Bund yields. Still, it will be more resilient compared to that of other countries.