Halister News

(Bloomberg) -- Euro-area disinflationary pressure is getting deeply entrenched; with shorter-end bunds already pricing in further ECB easing, the recent curve flattening shows ineffectiveness of policies in boosting inflation and nominal growth, Bloomberg strategist Tanvir Sandhu writes.

• 5s30s curve is at 127bps, near 115bps hit earlier this month, and is 42bps below last year’s steepest level
  • It’s now at the 50% retracement of flattening move from summer 2014 oil slide
• The bull flattening of the curve may extend further unless ECB cuts the depo rate by more than 10bps in March or removes the floor on the yield for QE purchases
  • The curve had flattened aggressively from 2H 2014 into 1Q 2015 amid heightened deflationary fears
  • EUR inflation curve pricing shows investors pessimism that ECB’s target of close to 2% will be met even in 20 yrs, with option premiums to protect against inflation near lowest level since Bloomberg started compiling the data in 2009
• Generic 2-yr bond yield is at -0.52%, well below the ECB deposit rate of -0.30%, making the bonds ineligible for QE purchases
• Renewed U.S. recessionary concerns, slide in oil prices and fallout of China slowdown have fueled flight-to-quality demand for longer maturity bunds
• The distortionary effects of ECB’s easing policy on the curve will be further amplified if the central bank changes its purchase rules

• SCENARIOS

• An aggressive depo rate cut will steepen the curve but such a move isn’t an obvious choice for Draghi
  • The recent widening of European banking credit spreads, which induced a peripheral blowout, highlighted that banks’ profitability could come under increased pressure on continued depo rate cuts
• Further QE purchases alone will have a flattening bias in 5s30s, without changes to purchasing rules
  • Potential for longer-end steepening, e.g. 10s30s, as inflation markets may perceive the move as positive via the credit channel
  • Increasing QE too aggressively may give rise to scarcity issues but ECB can counter this by increasing issue limit for purchases from 33%
• Removal of the floor yield on purchases would have an immediate steepener impact as ECB will be eligible to buy short-dated bonds they couldn’t before

• NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.