Rates Spark: Bonds Pick Sides

After much hesitation, rates markets are no longer sitting on the fence. Massive flight-to-quality moves are evident across currencies and tenors, and the market seems convinced that the European Central Bank is about to strike a much more cautious tone at its March meeting.
 

The Russian dollar bond curve is now priced as if in a state of default. Bonds that are supposed to pay USD 100 at maturity are priced in the market place in the area of 30 to 50 cents, and the curve is heavily inverted with the ultra-front end yield technically in the area of 1000%. Being a low debt economy, Russia can afford to service these bonds, but its ability to pay has been compromised by the back and forth on sanctions. To boot, investors are questioning Russia’s willingness to pay. Hence there has been an exodus, and especially as Russian debt is also on index-watch, where exclusion from emerging market indices would warrant forced selling in any case. Local currency ruble debt is under pressure too, and as the central bank has put a hold on coupon payments, is undergoing a technical default. A key parallel element has been a flight into US Treasuries, and Western European bonds.

Markets have made up their mind about ECB policy

A number of factors are behind the plunge in government bond yields. The obvious one is a flight to safety as the situation in Ukraine worsens and as geopolitical tensions rise. The second order effect is also the re-pricing of central bank tightening odds in euro and sterling markets. We’ve argued that the rates market’s reaction to events in Ukraine was surprisingly muted at their onset. This is no longer the case. In a sense, one could view yesterday’s massive bond rally as a delayed reaction to events taking place since late last week.

The belated bond rally reflects both flight to safety and hopes of more dovish central banks
 

Source: Refinitiv, ING

All explanations have their merit and, together, they suggest rates markets no longer sit on the fence. The cautious, even dovish, tone struck by ECB speakers was taken by markets as a sign normalisation is some way off. In our view, it is better characterised by Rehn’s ‘prudence and optionality’ mantra. As a result, the rally in Italian bonds outpaced that of their German counterparts, and front-end rates delayed the date of the first full 25bp rate hike to 2023.

BoE hike expectations are coming back to earth

Source: Refinitiv, ING

More evidence of a flight to safety

Despite scant communication from the Bank of England so far, sterling rates have seen the more aggressive re-pricing. We’ve long been of the view that the amount of tightening implied by the curve was far in excess of what the Bank was likely to deliver. Bear also in mind that the BoE has already hiked twice in this cycle, against none from the Fed or the ECB. As a result, it isn’t all that surprising that gilts would see the largest move in outright terms.

Widening German swap spreads are further evidence of a flight to safety

Source: Refinitiv, ING

Swap spreads is another place where a spectacular re-pricing occurred. The dip in Bubill yields suggests continued bond scarcity issues but we think the bulk of the widening of euro swap spreads has more to do with a classic flight to safety. On paper, the Deutsche Finanzagentur’s reported willingness to provide more liquidity to the repo market, combined with the likely additional issuance of money market instruments to finance additional deficit spending, should eventually ease bond scarcity.