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European economic figures look likely to confirm the underlying health of the economy, and with the Bund nearing the June highs of 165.50, reducing duration (or going short futures) looks more attractive than increasing duration right now.
The steep front end of the European curve vs the US curve prompts us to recommend a box trade even though upcoming European data should be strong.
Bund resistance at 165.50 may check the July/August rally; this, in turn, means Bund-Bono spread widening could soon reverse. Cash flow may matter more than Brexit news for Gilts into 4Q.
The trend of rates near term may have less to do with growth and inflation prospects than with risk aversion, given that many commentators are getting nervous about the level of risky assets, from credit to equities to peripheral sovereign markets, as per Societe Generale. Yet European spread differentials may have less to do with risk aversion that investors currently think. The left-hand chart below plots the change in the 10yr Bund-Bono spread with the level of 10yr Bonos.
From this, it seems like most of the move in the spread is due to changes in the Bund, not changes in views on Spain. If we are right then about Bund yields correcting higher, spreads may be likely to dip.
By contrast, the front end of the Euro curve has steepened following relatively strong growth figures. More may be on the way, yet the slope in the front end of the euro curve looks steep vs the US. Hence, box trade is recommended between the two curves, paying USD 2y1y vs 1y1y and receiving EUR 2y1y vs 1y1y.
Repricing of Fed hike risks while ECB could lag The US rates team have advanced the idea that the front end of the US curve is too flat and have suggested 2y1y vs 1y1y or reds/greens Eurodollar steepeners (see Trading a hawkish repricing of the Fed). In contrast, the flattening seen over the summer in the front end of the EUR curve has been modest. The 2y1y-1y1y spread is just 8bp off recent highs, which were themselves the steepest in three years (refer above graph). There are risks that EUR strength prompts the ECB to act more cautiously in reducing stimulus which should flatten the curve.
