No More Periphery Yield Compression Without QE

From a technical perspective, the rally in European periphery government debt since the beginning of 2014 appears to be running out of steam, with yields approaching all-time lows and momentum indicators appearing overstretched. From a fundamental standpoint, we also question whether current yields adequately reflect credit risk. However, anticipation of addition European Central Bank (ECB) easing will continue to be the main driver of yield dynamics in the coming months, implying scope for some additional yield compression.

While falling inflation across the eurozone has propped up real returns and supported demand for periphery government debt, yield compression is being driven primarily by improving perceptions of credit risk as opposed to inflation dynamics. The spread of Italian over German 5-year credit default swaps has fallen to pre-eurozone debt crisis levels, highlighting just how much sentiment towards the periphery has improved. This is in spite of the region's pernicious dynamic of low growth potential and large public debt loads that make some form of restructuring over the next decade a distinct possibility.

We see a low probability of any sudden spike in short or long-term inflation expectations, implying that perceptions of credit risk will continue to be the main driver yield differentials. With Italy returning to very modest economic growth in Q413 growth and the outlook for political stability much improved, from a domestic standpoint we see few short-term risk factors that could cause a sudden reversal in perceptions of credit risk. More likely, in our view, is that improving sentiment has come as far as it can go on the back of the ECB's pledge to do whatever it takes to save the eurozone, implying that periphery yield compression has reached its limit absent further ECB action.

Pulling Back From All-Time Lows
Italy - 10-Year Government Bond Yield, %, Monthly

No More Periphery Yield Compression Without QE

From a technical perspective, the rally in European periphery government debt since the beginning of 2014 appears to be running out of steam, with yields approaching all-time lows and momentum indicators appearing overstretched. From a fundamental standpoint, we also question whether current yields adequately reflect credit risk. However, anticipation of addition European Central Bank (ECB) easing will continue to be the main driver of yield dynamics in the coming months, implying scope for some additional yield compression.

Pulling Back From All-Time Lows
Italy - 10-Year Government Bond Yield, %, Monthly

While falling inflation across the eurozone has propped up real returns and supported demand for periphery government debt, yield compression is being driven primarily by improving perceptions of credit risk as opposed to inflation dynamics. The spread of Italian over German 5-year credit default swaps has fallen to pre-eurozone debt crisis levels, highlighting just how much sentiment towards the periphery has improved. This is in spite of the region's pernicious dynamic of low growth potential and large public debt loads that make some form of restructuring over the next decade a distinct possibility.

Narrowing Credit Spread Has Reached It's Limit
Spread of Italy Over Germany 5-Year Credit Default Swap, basis points

We see a low probability of any sudden spike in short or long-term inflation expectations, implying that perceptions of credit risk will continue to be the main driver yield differentials. With Italy returning to very modest economic growth in Q413 growth and the outlook for political stability much improved, from a domestic standpoint we see few short-term risk factors that could cause a sudden reversal in perceptions of credit risk. More likely, in our view, is that improving sentiment has come as far as it can go on the back of the ECB's pledge to do whatever it takes to save the eurozone, implying that periphery yield compression has reached its limit absent further ECB action.

That being said, we see ECB quantitative easing (QE) as an increasingly likely scenario in the coming months given the salient threat of deflation in the euro area. If this were to take the form of sovereign bond buying, as we would expect, this would entail further compression of both core and periphery eurozone yields. On the other hand, if the ECB were to rule out QE (not unlikely given Bundesbank opposition) we believe this would be negative for periphery fixed income, leading to a re-widening of core-periphery yield spreads.

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