Long end: US-EUR divergence trades look attractive

The price action over the past few months in longer tenors globally has mainly been about rising term premia. 

At current yield levels, term premia is close to zero in longer tenors, both in the US and euro area, estimates Barclays. A number of reasons are seen why global term premia should be negative. Risks to growth are still skewed to the downside as consensus growth expectations remain elevated despite the recent tightening of financial conditions globally. Inflation is still low globally and is more likely to undershoot central bank targets rather than overshoot, adds Barclays. 

Furthermore, after the sell-off, as seen sovereign bonds as offering a good hedge to a portfolio of risk assets in the event of a flight to quality, which should work to depress term premia. 

According to Barclays, debt levels will likely prove too high to be sustainable. Hence, risks are skewed towards term premia again becoming negative. On a relative basis, term premia is more likely to decline in the euro area than in the US. 

All else being equal, pushing out the cycle would allow for more reflationary forces to build, arguing for a continued build-up in term premia. On the other hand, in the euro area, the bar for the ECB to respond to recent events seems higher, despite the fact that Europe is much further away than the US from meeting its price stability mandate. All else being equal, a strengthening of the trade-weighted EUR should work to depress term premia in the euro area.

In light of these developments, most notably the dovish shift by the Fed at the June FOMC, Barclays increases year-end targets for 10y yields to 2.40% in the US (from 2.25% earlier) and to 0.70% in Germany (from 0.5% earlier), and expects US 10y to trade at 2-2.5% and Bunds to stay within 0.5-1% in Q3. 

Barclays's forecast are 10-15bp below forwards in the US but almost 30bp below forwards in Germany. A few weeks ago, they recommended a tactical long in US 10s; the sell-off caused by expectations of a deal in Greece has taken yields almost back to levels where we initiated the trade.