ECB has removed uncertainty from the market
Investors in the European fixed income markets welcomed the ECB announcement. The central bank has removed the risk of a rate hike in the foreseeable future, and in fact it may present the market with more small 'gifts' in coming quarters.
In the bond markets, this creates a clear incentive to hunt for extra return. Investors are focusing on carry trades. The obvious strategy is to buy high-yield Italian government bonds, as Italian banks are set to benefit from the new TLTROs.
However, investors are also pushed further out the yield curve in safe havens like Germany. Given the ECB's new easing bias and forward guidance, policy rates are set to remain negative for a very long time.
To avoid negative German government bond yields, investors should again buy 10Y bonds. Yields on 10Y bonds may very well also be pushed into negative territory in coming months, which would only push investors further out the yield curve.
So, while the ECB's downward revision of its growth and inflation forecasts may not have come as a major surprise, the ECB response was stronger than we had expected.
10Y Bund yields set to remain close to zero for the rest of 2019
Given the spate of uncertainties and the weakening economy already witnessed in 2019, coupled with the latest ECB announcements, we no longer expect an ECB rate hike in December; nor do we expect any noteworthy increase in 10Y yields on a 12M horizon.
In other words, we expect the benchmark Bund yield to be trading in a tight -0.1% to +0.25% range throughout 2019, with mainly risk appetite determining at which end of that range yields would be.
For the next couple of months, we expect yields to trade at the lower end of this range. However, as some of the risks disappear and growth starts to improve, which is still our baseline scenario, yields could move to the high end of the range.
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