The focal point in the European bond market at the moment is the political situation in Italy. Since the beginning of May Italian 10-year yields have widened more than 140bp, and the spread to Germany is now above 260bp while the outright 10-year yield has been above 3% in Italy. We have to go back to 2013-14 to see similar levels for Italian yields and spreads. There is a genuine risk that a new debt crisis is on the way in Italy and the impact on the financial markets outside Italy has been sizeable.
Investors have sought shelter or safe-haven in the German government bond market and 10-year German Bund yields have been more or less halved in a week to currently 0.35%. It has also dragged swap-rates lower, though the drop in swap-rates has been slightly more modest as the asset-swap spreads have widened (bond yield versus swap rate).
The drop in German government bond yields has been mirrored in the Scandinavian markets given the strong underlying fundamentals of Denmark, Norway and Sweden.
The big question is of course whether the Italian crisis is going to continue setting the agenda for the rest of 2018. There is a non-negligible risk that this is turning into a full-blown new debt crisis where the upcoming election campaign will focus on Italy leaving the euro, massive fiscal easing and debt restructuring. In that case the recent downward pressure on EUR and Scandi rates and yields will continue. The market will probably start to price out any probability of the ECB hiking rates in the next three years. In this scenario our yield and rate forecasts are far too high.
However, it might also be that the crisis dynamics have peaked, the Italian politicians soften the rhetoric and investors take advantage of the high yields the Italian market currently offers, and we see a stabilisation in Italian yields and spreads. We will probably not move back to the spreads seen before the political jitters started and Italy might receive one or more rating downgrades. But importantly Italy will not set the agenda every day and the safe-haven flows into German bond markets will ease and the market will slowly start to focus on the usual drivers for the fixed income market.
We have in this update assumed the latter and we keep our yield forecasts more or less unchanged. We have revised lower some of the forecasts on a 3M horizon, but have made few changes to the 12M forecast. We also still forecast that the ECB will start to hike rates in the latter part of 2019.
But importantly, we keep the view that Nordic/European 10Y rates and yields will not rise significantly in 2018 and that higher 10Y yields would be very much a 2019 story. Short term we could potentially see a move higher if the recent flow into German bonds reverses.
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