Senior Fixed Income Strategist
Summary: In the United States, the rise in Treasury yields might slow down this week if violent protest escalates during the Presidential inauguration. In Europe, a political crisis in Italy, Netherlands, and Estonia may force the European Central Bank to tweak the Pandemic Emergency Purchase Programme (PEPP) favouring certain sovereigns. In our opinion, Italian BTPs continue to offer the most significant upside ahead of Thursday ECB's meeting even if the government is running the risk of earlier elections.
Although it will be a short trading week in the United States, everything can happen as Joe Biden is sworn as President. The reflation story will most likely continue to push Treasury yields higher; however, if violent protest escalates, there could be some upside for Treasuries in the short-term.
In Europe, investors will need to carefully consider opportunities in the European sovereign space before the ECB meeting on Thursday as political hurdles arise in various countries. The trading week will also be influenced by news from the European financial ministers' meeting and the German and Eurozone ZEW Survey coming out tomorrow.
It will be essential to examine Lagarde's wording at the European Central Bank’s press conference on Thursday as a political crisis unfolds in Italy, Netherlands and Estonia. Although in the last ECB's minutes was mentioned a possible rate cut if the bloc's economic outlook continues to deteriorate, we don't believe that there are yet elements for the ECB to take such a decision. The central bank will most likely maintain its policy on hold and use the Pandemic European Purchase Program to weight purchases towards selective countries to control a spike of spreads against the Bund.
Therefore, we believe that the volatility in Italian sovereigns, which saw the BTP-Bund spread widening in the past week, offers an excellent buying opportunity as the Italian BTPs will continue to be supported by the expansionary monetary policies of the ECB. Today and tomorrow Italy's Prime Minister Conte will seek to form a new majority in the lower house and the Senate. Suppose he fails to gather enough votes to form a new government. In that case, early elections will be called, which would see the BTPs falling further, representing a greater opportunity for bond investors ahead of the ECB meeting on Thursday.
While the upside in long-term BTPs can be substantial, we believe that such an upside is almost inexistent for Dutch government bonds for the simple reason that they are already trading in deeply negative yield territory. The Dutch 10-year sovereigns (NL0014555419) are offering -0.48% in yield, and the spread between the Netherland government bonds and the Bunds is the tightest since before the Global Financial Crisis in 2008 indicating that there is very little room for further tightening. The spread between Italian BTPs and the Bund, on the contrary, is quoting around 2016 levels. Due to the expansionary accommodative monetary policies of the ECB, the spread between BTPs and the Bund could fall to 75bps, a level previously hit in 2010. If that were the case, it would translate in an upside of approximately 4% and 16% for 10- and 30-year BTPs respectively.
Monday, January 18th
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