NN IP: Italian volatility still weighing on German Bunds

This year, the high volatility of Italian 10-year yields has driven investors into safe government bond assets. Figure 1 shows that at times of spiking Italian 10y bond yield volatility, there was a drop in German 10-year yields. This was clearly the case in May, when we saw a sizeable fall in the German 10-year yield, but in October we have also seen Italian bond yield volatility coinciding with declining Bund yields.

However, as of late summer we saw that German 10-year yields were tending to move higher. This was partly the result of a renewed rise in US 10-year yields. With positive correlations between the US and German yields, there was a pass-through of higher US yields into German yields. A second factor is a repositioning that has taken place among European investors with respect to duration exposure. While investors in Europe were significantly underweight duration at the beginning of the year, our analysis of European investor duration exposure shows a repositioning from late April to late June. Therefore, the repositioning had already started before we saw the blowout of Italian spreads in May, which probably also triggered a further repositioning on duration. Currently, the underweight duration exposure in European fixed income portfolios is moderate (unlike in the US, where underweights seem extreme).

Recent weakness across the periphery

Figure 2 shows that over the past few weeks the widening of spreads is not only taking place in Italy but also in other peripheral countries like Spain and Portugal. In our view, this is the result of global factors, some Italian spillover and specific factors. Globally, we have seen rising investor risk aversion, which has also had an impact on European peripheral bonds. In addition, the Italian rise in spreads has probably led to some spillovers into Spanish and Portuguese bonds. These spillovers appear to have been a bit stronger over the past weeks than during the previous months. And there have been some specific factors affecting Spain which, against a background of negative market sentiment, caused a widening of the Spanish 10-year bond yield versus the German 10-year yield.  Spanish spreads have also been affected by a negative news flow (related to the payment of mortgage taxes) regarding the Spanish banking sector.

The US 10-year yield is much less vulnerable to rising uncertainty compared with the German 10-year yield as there is a much stronger underlying trend due to the normalization of US monetary policy. Figure 3 illustrates that the trend in US 10y yield is much smoother than in Germany. The result is that the gap between the US 10-year yield and the German 10-year yield continues to widen. In the past week, the spread reached a new peak of above 275bp. The spread will likely remain elevated for quite a while, as the Fed continues on its normalization path and the ECB is not likely to hike until at least the second half of next year.