0405 GMT January 19, 2022
Europe’s bond markets are sending a signal that the latest selloff may be far from over.
Hedging costs are rising in tandem with bond yields as anxious traders prepare for the rout to get worse. It’s the first time that’s happened since 2016, when the European Central Bank (ECB) rocked the market by announcing it would begin to scale back its bond-buying program, Bloomberg reported.
Today, the prospect of a pickup in consumer prices is the driver. Hefty stimulus in the US and vaccine rollouts in the European Union sent a market proxy of expected inflation to the highest in over two years earlier this month, driving up the yield premium on longer-dated bonds. European debt has bruised holders with a 2% loss so far this year, according to Bloomberg Barclays Indexes, the worst start to the year since 2017.
“Investors are more keen to protect against a rise in rates than a fall, suggesting there is more pain,” said Marco Meijer, a senior G-10 rates strategist at BNP Paribas SA in London. Dealers taking the other side these trades also need insure their positions, creating an even bigger short position. “This could lead to an amplified move,” he added.
Over the past two months, the one-year, ten-year swaption – a gauge of volatility – has moved up in tandem with the spread between 10- and 30-year yields, a break from a dynamic that’s seen bond yields and hedging premiums move in opposite directions for much of the past five years.
Other forces are at play too. For example, Dutch pension funds don’t need to hedge their long-dated holdings as much as before. This has the effect of removing a consistent buyer from the market, leading to a steeper curve. The narrowing premium between the duration of liabilities and the assets held against them by pension funds and life insurance companies also tends to push up long-dated yields.
There are signs momentum from the reflation trade is also filtering into other corners of the market. The so-called five-, 10- and 30-year swap fly – a measure of how sensitive the 10-year sector is relative to its peers – has stopped declining.
“This is consistent with the acceleration in the yield sell-off and increasing rates volatility,” Societe Generale SA strategists led by Adam Kurpiel wrote in a note.