Rates: How To Stay Positive

We expect risk aversion to prevail this week, but find the risk-reward of peripheral debt attractive even if we're wrong. Weekly data shows that the ECB's asset purchases continue at a strong pace, effectively managing financing costs as governments splurge on crisis-fighting measures.

Source: Bloomberg, ING

Peripheral debt has the best risk-reward

Within the Euro Government Bonds (EGB) space, the outperformance of the belly of peripheral curves is a strong sign that the ECB has acquired some well-earned credibility in calming market gyrations. In an environment where the central bank is credible in its intention to keep borrowing costs low, investors have an incentive to seek the best carry opportunity within the realm of bonds purchased. In EGBs, this means Italy and the periphery more broadly.

It is in theory possible for the ECB to supress EGB yields on average, as measured by the GDP-weighted composite 10Y EGB rate, whilst an individual market is selling off. In practice, correlation between peripherals is such that it is hard to foresee a shock that would affect only one of the smaller countries. For the larger ones, such as Italy and Spain, their relative volatility and size make their outperformance preconditions for the whole index to remain in check.

Should the ECB continue to advertise this measure of financial conditions as a prime target, we expect the convergence of peripheral debt to gather pace. This is just as well - our assessment of the external environment is not rosy. We are no epidemiologists, nor equity experts, but accelerating covid epidemic and rising optimism in risk markets seem hard to reconcile. We would stop short of making a call on markets other than rates but peripheral bonds appear to offer a particularly attractive risk-reward: we trust their ability to rally in all but the worst market environment, thanks to ECB intervention.

ECB purchases continue unabated

ECB asset purchases continue at a strong pace. The pandemic emergency programme purchases (PEPP) amounted to €28bn over the course of last week, the highest volume in four weeks. That the public sector net purchases (PSPP) turned out lower at €3bn is most likely due to larger bond redemptions. These amounted to €29bn in total and the ECB will have held some of those bonds.

The importance of PEPP cannot be stressed enough. The outsized fiscal response would in some countries not be possible without the ECB’s intervention keeping a lid on government financing costs. ECB’s De Guindos stated yesterday that rising debt “raises fragmentation issues” and that debt levels need to be managed in the medium term. In the short term they are managed by the ECB rather effectively as is evidenced by Italian government bond spreads over German counterparts retightening further even as Italy mulls additional government spending, including a temporary but still costly VAT cut.

 

Source: ECB, ING

Today's Events: Eurozone PMIs

We don't think markets will put much faith in today's PMIs, due to their nature as diffusion indices measuring only the breadth but not the depth of economic variations.

Sovereign supply today consists in 20Y Netherlands, a green bond, and 2Y Germany sales.