Despite the recent downgrades by Standard & Poor's and Fitch, Royal London Asset Management reports that a relative stability has settled over European government bond markets as risk assets rally.
George Henderson, Manager of the Group’s Global Index Linked Fund, confirms that spreads on Italian 10 year bonds (over German bunds) have tightened 80 basis points and are now trading at 410bps over. The current absolute 10 year yield has breached the psychologically important 6% level to the downside.
“In my view, positioning is having a larger effect on markets than fundamentals and we can see this through the reaction to auctions. Firstly, Spain auctioned 10% of its annual funding requirement earlier this month, meeting solid demand for its debt, while the following day an Italian auction was met with poor demand. Ratings downgrades by Standard & Poor's then followed, and both government debt markets began rallying.” Henderson says this is what has brought some stability despite markets continuing to “feel fickle”.
“I suspect the ‘pain trade' is for risk assets to continue rallying, either as investors have positioned themselves for a fall in risk markets, or remorse as they have missed the ‘buy' opportunity of their careers. However, conviction levels remain low and the environment is extremely volatile. In the near term, political developments and headlines will drive volatility and with fiscal pacts requiring ratification, politicians angling for re-election and disputes between lender and creditor countries, there is a wealth of material to trigger sharp moves.”
It is Henderson’s belief that this requires a contrarian strategy, given the volatility of markets and their tendency to over-react. He confirms that as yield levels are at multi-year (even generational) lows, he has been managing this approach from the short duration side. He adds reassuringly, “Over the longer term, I don't expect a European break-up. Too much political capital has been invested in the project and it is in very few people's interests for it to disintegrate.” However, he does bring in a cautionary note by adding that as Europe stumbles towards a higher level of fiscal integration and creates or reorganises the accompanying institutions, he is expecting markets to remain extremely volatile.
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