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Investment Research

11 February 2018

Fixed Income strategy The 10Y segment most exposed if the FI sell-off continues The FI sell-off becoming sizeable

Key points

This year has started with a fixed income sell-off that has pushed the 10Y Bund yield higher by c.30bp since the year began and close to 45bp since mid-December 2017.

 The market is pricing both the ECB

If we compare the sell-off with the US-induced 2013 tapering sell-off or the 2015 Bundled sell-off, the market moves are still smaller. In 2013, the 10Y US Treasury yield rose close to 100bp in the first two month of the tapering sell-off and in 2015 10Y Bund yields rose 60bp in the first two months of the sell-off alone and peaked two and a half months later more than 80bp higher overall.

and Fed relatively aggressively, but there is still room to price in: (1) a higher term premium due to higher volatility; (2) higher inflation expectations and (3) a higher real rate.

In this research note we look at potential drivers for a ‘new leg’ in the ongoing sell-off. We conclude that the market is pricing both the ECB and Fed relatively aggressively, but there is still room to price in: (1) a higher term premium due to higher volatility ; (2) higher inflation expectations and (3) a higher real rate. Hence, we argue that the risk is moving further out on the yield curve. If the FI market comes under further pressure, the 10Y segment would be the most exposed point on the curve in our view. The 2018 Fixed Income sell-off starting to look sizeable

 Hence, we argue that the risk is

moving further out on the yield curve. If the FI market comes under further pressure, the 10Y segment would be the most exposed point on the curve in our view.  We stick to the view that the

10y30y curve will flatten further in 2018.

The 2y2y EUR swap rate has jumped more than 40bp over a short period 0.80%

Source: Macrobond Financial, Danske Bank

0.70% 0.60% 0.50% 0.40%

0.30% 0.20%

The 5y mark has been the turning point so far in the EUR curve… The moves seen in the European curves over the last two months reflect to a certain degree what we have seen over the p ast couple of years in the US. First of all, the 5y mark has become the pivotal point on the curve. This is right after the textbook typical pattern seen when monetary policy is about to change.

0.10% 0.00% -0.10% Feb17

May17 SWAP 2Y 2Y EUR6M

Aug17

Dec17 Last observation

Source: Danske Bank

Head of Fixed Income Research Arne Lohmann Rasmussen +45 45128532 [email protected]

Important disclosures and certif ications are contained f rom page 6 of this report.

www.da ns ke re se arc h.c om

Fixed Income strategy

On the EUR swap curve, the 2y5y curve has steepened and it is noteworthy that the 5y10y curve has only recently started to steepen after flattening in Q4. The result is that the 2y5y10y ‘butterfly’ has moved higher over the p ast month. The pressure on the 5y segment is also very visible looking at the 2y2y EUR6m swap rate, which has jumped from around 0.3% to above 0.7% currently.

2y5y and 5y10y curves moved in different directions in December

The 5y point has pushed the 2y5y10y butterfly higher

Source: Danske Bank

Source: Danske Bank

The market is pricing in a 10bp hike by the ECB in Q1 and that the deposit rate would reach zero by end-2019 and 1% in autumn 2022.

The market is pricing the first hike in Q1 and the depo rate turning positive by end-2019

Pronounced repricing of ECB expectations over the past three months (EUR OIS 1M fwd curve)

1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% -0.20% -0.40% -0.60% Nov17 Source: Danske Bank

Current live

Oct18

Oct19

3M ago

Oct20

Oct21

Source: Danske Bank

Focus moving further out on the curve We argue that it would be difficult to price the ECB any more aggressively, especially in 2019, and hence that we need an even steeper curve in the 2020-2023 segment to push the 5y point a new leg higher from the current level. Instead we argue that the focus point has moved to the 10Y segment of the curve and that 5y10y would steepen further if the bearish market continues. We focus below on two factors that add upside risks to the 10y segment of the European curve in particular.

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Oct22


Risk factor 1: Higher term premium if rate volatility moves higher A starting point would be to look at the ‘term premium’ that theoretically reflect s the premium an investor demands in order to buy a long bond, for example a 10-year bond instead of buying ten one-year bonds covering the next ten years. It is not observable in the market and can only be estimated. We use the publicly available term premiums for the US treasuries published by the New York Fed based on the Adrian, Crump and M oench model. Term premium moves are normally highly correlated across markets. It is well-known generally that the 10-year term-premium is highly correlated with the 5y10y curve and influenced by interest rate volatility. If the latter goes up , one should expect that investors will demand a higher risk/term premium for holding long bonds. As shown in the charts below, for the US these two factors are very important and a simple OLS regression indicates a relatively good fit, as illustrated in the chart to the right.

Interest volatility and 5y10 curve can explain the term premium in the US

Source: Bloomberg, Danske Bank

The US term premium has started to move marginally higher

Term premium and the 5y10y curve (US)

Swaption volatility and term premium

Source: Bloomberg based on Adrian, Crump and Moench

Source: Bloomberg

Source: Bloomberg

Hence, the key to understanding if we could see a more pronounced rise in the global term premium is whether interest rate volatility will continue to move higher in 2018. Interestingly, the EUR rates volatility market has been somewhat resilient to the relatively large moves in outright EUR rates.

No significant spike in EUR rates realised volatility. Implied volatility has stayed relatively muted 140

bp

120

Looking deeper at the market reaction on the back of the latest ECB meeting, realised 10Y EUR rates volatility has been relatively subdued compared to the moves in outright EUR rates. This seems to have put a lid on implied EUR rates volatility as well. Hence, the volatility term structures across different tails (tenors) are still fairly steep.

100 80 60

40 20

Besides, in carry terms, it is still expensive to be long EUR rates volatility. This supports relatively steep EUR rates volatility term structures and continues to keep EUR rates implied volatility close to historical lows.

0 Jan-15

Jul-15

Jan-16

Jul-16

Jan-17

Jul-17

Jan-18

EUR 1Y10Y 20d Realized Volatility EUR 1Y10Y 60d Realized Volatility

EUR 1Y10Y Implied Volaitlity

But the question for us is, what could push interest rate volatility higher? Carry-unwinding is an obvious risk factor. It has been a consensus trade to sell volatility. Particularly after the recent stock market sell-off, this is an evident risk. However, given that the vol. curve remains steep, this could drive the market only to a limited degree if we do not see a spike in realised volatility. The latter is the main risk and could be triggered if a surprise eventuates, particularly in inflation prints and inflation expectations over the coming quarters.

Note: Normal implied volatility reported as bp/year. Realised volatility computed as 20days average of squared daily changes in underlying swap, reported as bp/year. Source: Danske Bank

Another obvious risk to the term premium is a potential QE premium in the curve. This is especially relevant for the EGB market ahead of the possible end to QE later this year. Not

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least of all seen in light of the US tapering sell-off in 2013. But also the US curve could see an impact from the Fed’s quantitative tightening.

Risk factor 2: A move higher in real rates Another important theme in 2018 could be real rates. It is noteworthy in our view how real rates have stayed negative for several years in the Euro zone and have only recently started to move higher. The real rate is closely related to the natural ‘real’ rate that dropped significantly after the financial crisis. But it is noteworthy that most estimates now indicate that the natural rate has started to move higher. Here we use the Laubach Williams estimates for the Euro zone, which are available from the Federal Reserve Bank of San Francisco. They show that the natural rate moved above zero for the first time in four years in 2017. We only have data until Q3 2017, but given the growth in the European economy in Q4 and Q1, we estimate that the natural rate will continue to move higher in 2018 if investments pick up. But remember the natural rate is not as such a reflection of the output gap but primarily decided by investment and savings patterns and trend growth.

Natural real rate is still low in the Euro zone

Source: Bloomberg, Macrobond Financial

If the natural real rate were to slowly start to move higher and the output gap continue to close, we would expect the market to start to price in higher inflation expectations and a higher real rate. We have already seen that market-based inflation expectations have moved higher both in the Euro zone and the US. It is part of the renewed focus on ‘reflation’ that has dominated the financial markets since the autumn, as it has become clear that the global economy is in a synchronic recovery. But even after the recent move higher, inflation expectations including 5y5y expectations are still well below levels seen in 2010-2013.

Breakeven rates have moved higher

But 5y5y is still well below the level seen 5 years ago 3.5

5Y 5Y USD inflation

5Y 5Y EUR inflation

3 2.5 2 1.5 1



M ore important in our view is how real rates have developed. Here we look at 2y,5y and 10y EUR real rates based on EUR inflation swaps. We have seen a move higher in real rates, but the move is still relatively modest. If real rate expectations start to move higher this would pose yet another risk factor for global yields. This is mainly a concern for the pricing of the EUR swap curve as US real rates have already moved into positive territory, as shown in the charts below.

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Real rates are low… but they have slowly started to move higher (based on swaps)

Upside for real rates in the 10y segment Real rate curve, EUR 2.50

EUR swap curve

EUR inflation curve %

%

0.00 -0.20

2.00 -0.40 1.50

-0.60 -0.80

1.00 -1.00

Here we see upside for real rates and swap rates

0.50

-1.20 -1.40

0.00

-0.50

Source: Danske Bank

1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 11y 12y 13y 14y 15y 16y 17y 18y 19y 20y 21y 22y 23y 24y 25y 26y 27y 28y 29y 30y

-1.60 -1.80

Source: Danske Bank

Conclusion: Risk to the upside for 10Y yields and steeper 5y10y curve The combination of the global synchronic recovery, focus on US fiscal policies in 2018 and 2019 and global central banks turning less dovish has been a toxic mix for global fixed income markets. The result has been a significant underperformance for the 5y segment of the EUR curve.

USD real rates are already at a higher level (based on swaps)

The market is pricing in both the ECB and Fed relatively aggressively but there is still room to price in a higher term premium due to higher volatility, higher inflation expectations and a higher real rate. Hence, we argue that the risk is moving further out on the yield curve. If the FI market comes under further pressure, the 10Y segment would be the most exposed point on the curve. Source: Danske Bank

We still look for a flatter 10y30y curve We emphasise that we stick to the view put forward in our FI strategy: The big EUR curve flattening has started published in January 2018 that the 10y30y curve has further flattening potential.

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Disclosures This research report has been prepared by Danske Bank A/S (‘ Danske Bank’ ). The author of this research report is Arne Lohmann Rasmussen (Head of Fixed Income Research). Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’ s pers onal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the sp ecific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdi ctions where it conducts business. 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More information about the valuation and/or methodology and the underlying assumptions is accessible via http://www.danskebank.com/en-uk/ci/Products-Services/Markets/Research/Pages/researchdisclaimer.aspx. Select Fixed Income Research Methodology. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Completion and first dissemination The completion date and time in this research report mean the date and time wh en the author hands over the final version of the research report to Danske Bank’ s editing function for legal review and editing. The date and time of first dissemination mean the date and estimated time of the first dissemination of this research report. The estimated time may deviate up to 15 minutes from the effective dissemination time due to technical limitations.

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See the final page of this research report for the date and time of completion and first dissemination. Validity time period This communication as well as the communications in the list referred to below are valid until the earlier of (a) dissemination of a superseding communication by the author, or (b) significant changes in circumstances following its dissemination, including events relatin g to the market or the issuer, which can influence the price of the issuer or financial instrument. Investment recommendations disseminated in the preceding 12-month period A list of previous investment recommendations disseminated by the lead analyst(s) o f this research report in the preceding 12-month period can be found at http://www.danskebank.com/en-uk/ci/productsservices/markets/research/pages/researchdisclaimer.aspx. Select Fixed Income Trade Recommendation History Other previous investment recommendations disseminated by Danske Bank are also available in the database. See http://www.danskebank.com/en-uk/ci/products-services/markets/research/pages/researchdisclaimer.aspx. for further disclosures and information.

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Re port completed: 9 February 2017, 15:10 CET Re port first disseminated: 11 February 2018, 17:45 CET

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