Calling A Bottom In 10-Year Government Yields

We believe that Italian 10-year government yields have reached an inflection point after falling to all-time lows in mid-April, and are initiating a bearish asset class strategy view at an entry level of 3.16%. This is not based on expectations of deteriorating credit risk, and as such we do not expect a spike in borrowing costs similar to those witnessed in 2011 and 2012. Instead, we see yields gradually rising as a result of an improving growth outlook and a bottoming out of disinflation in the eurozone. The technical picture also suggests that the momentum underpinning the sustained rally in Italian fixed income is waning.

Disinflation, in conjunction with improving perceptions of credit risk on the back of the European Central Bank's Outright Monetary Transactions (OMT) programme, have supported fixed income demand and driven a strong positive correlation with equity performance. As we remain bullish on Italy's FTSE MIB equity index in our asset class strategy, we expect this correlation to abate.

It is our view that the OMT's effect on narrowing credit risk in the eurozone periphery has largely run its course, with the spread of Italian over German credit default swaps at pre-eurozone crisis levels. More recently, eurozone disinflation has caused markets to price in a relatively high probability of the ECB enacting some of sort quantitative easing (QE) programme, strengthening the risk-free perception of periphery government debt.

Overstretched
Italy - 10 Year Government Bond Yield, weekly, % And Relative Strength Index (bottom)

We believe that Italian 10-year government yields have reached an inflection point after falling to all-time lows in mid-April, and are initiating a bearish asset class strategy view at an entry level of 3.16%. This is not based on expectations of deteriorating credit risk, and as such we do not expect a spike in borrowing costs similar to those witnessed in 2011 and 2012. Instead, we see yields gradually rising as a result of an improving growth outlook and a bottoming out of disinflation in the eurozone. The technical picture also suggests that the momentum underpinning the sustained rally in Italian fixed income is waning.

Overstretched
Italy - 10 Year Government Bond Yield, weekly, % And Relative Strength Index (bottom)

Disinflation, in conjunction with improving perceptions of credit risk on the back of the European Central Bank's Outright Monetary Transactions (OMT) programme, have supported fixed income demand and driven a strong positive correlation with equity performance. As we remain bullish on Italy's FTSE MIB equity index in our asset class strategy, we expect this correlation to abate.

Turning Point
Italy - 10 Year Government Bond Yield, daily, %

It is our view that the OMT's effect on narrowing credit risk in the eurozone periphery has largely run its course, with the spread of Italian over German credit default swaps at pre-eurozone crisis levels. More recently, eurozone disinflation has caused markets to price in a relatively high probability of the ECB enacting some of sort quantitative easing (QE) programme, strengthening the risk-free perception of periphery government debt.

Pricing Out Eurozone Debt Crisis
Europe - Spread Of Italy Over Germany 5-Year CDS Spread, bps

However, we believe that market expectations may be overblown given the ECB's restrictive mandate and that eurozone inflation is likely to pick up in the coming months. Recent comments by ECB governor Mario Draghi also suggest that QE would require a significant deterioration in the inflation outlook, which we do not currently expect.

False Break?
Italy - 10 Year Government Bond Yield, monthly, %

Our forecasts imply a gradual pick-up in inflation in H214 across all major eurozone economies. That being said, the potential for disinflation to persist represents the key risk to our view, as it would imply further downside for periphery yields by supporting real returns and boosting the chances of a QE programme from the ECB.

BMI Europe Asset Class Strategy
DATE INITIATED ENTRY LEVEL GAIN/(LOSS) RATIONALE
CURRENCIES
Bullish RUB/TRY 18-Mar-2014 16.4 2.3% Turkey offers a more attractive long-term investment story and positive carry, while lower oil prices will expose Russia's massive economic challenges.
FIXED INCOME
Bearish Italy EUR 4.5% 2024 Government Bond 29-Apr-2014 3.16 - Re-pricing of credit risk has run its course, with improving growth outlook and bottomoing out of eurozone inflation to drive yields gradually higher. Technical picture suggests reversal in momentum.
EQUITY INDICES
Eurozone Over US Equities (Ratio of MSCI US to MSCI EMU) 15-Aug-2013 17.3 1.4% Though we still like the US, eurozone underperformance has reached extremes, and the eurozone economy is picking up momentum. The MSCI EMU looks attractive on a technical basis and is increasingly cheap versus the US. Targeting a move down in the US/EMU ratio to 14.0x.
Bullish Italian FTSE MIB Index 28-Mar-2014 21,345.5 2.4% Constructive technicals, positive political developments and low relative valuations.
MACRO/INDUSTRY STRATEGY
NA
Source: Bloomberg, BMI

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