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Bloomberg News

Bloomberg News

Greg Ritchie

(Bloomberg) — A crazy week for trading Europe’s bonds means investors are betting on the biggest swings in a decade.

An index of German debt, meant to be the continent’s haven, just swung from its best week to its worst ever. Investors across the region have been whiplashed with the biggest ranges since the Covid panic of 2020. A gauge of future rates volatility is now the highest since 2011.

Nobody said trading a group of divergent economies tied together with the same monetary policy was going to be easy. For years though, the broad trend has seen yields falling and the premium for riskier economies narrowing as the European Central Bank propped up markets with trillions in bond buying. That bullish trade is now under threat.

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“Asset purchases have been used as a blanket to smother the sparks of uncertainty in Europe for the last decade,” said Oliver Blackbourn, a fund manager at Janus Henderson Investors. “With a geopolitical shock of unknown length and intensity still on-going, markets have clearly been surprised by the ECB’s decision to start reducing this safety net.”

Bonds have been battered in a week that saw the ECB unexpectedly accelerate its wind-down of stimulus programs as well as reports of plans for massive debt sales by the bloc to fund energy and defense spending in the wake of Russia’s attack on Ukraine.

While the spread of Italy’s yields over Germany, a gauge of risk, slid Tuesday by the most since 2020 on hopes for fiscal risk-sharing, it then blew out again Thursday by the most since 2020 as Rome has been a major beneficiary of the ECB’s largesse. That erased Italian bondholders gains in a flash.

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Similarly, sentiment has been yo-yoing on an almost daily basis between using bonds as a hiding place against the war or as a stick to beat with record inflation. Investors have also been dumping corporate debt and it’s been a wild ride for equity markets too.

Citigroup Inc. and JPMorgan Chase and Co. now recommend shorting Italian debt versus Germany, since the ECB’s asset purchases may end in the third quarter. Citigroup strategists expect the spread to reach 190 basis points, from 160 currently. Options traders are also bearish on the euro, which neared $1.08, its weakest since May 2020.

The bloc’s periphery “is fearful of less support coming from the central bank,” said Althea Spinozzi, a fixed-income strategist at Saxo Bank A/S. “The central bank stated clearly that monetary policies will tackle inflation, while fiscal policies will need to look at growth.”

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The ECB is grappling with the challenge of sheltering the euro-area economy from the consequences of Russia’s invasion while also acting to contain price increases. Europe is more exposed to the repercussions of the war due to its proximity to the Russian economy and reliance on it for key commodities including natural gas. 

With the ECB prioritizing its mandate of price stability, money markets are betting it will hike by a quarter-point in October and follow that up with two more in early 2023. Of course that projection could quickly change, leading to options bets on front-end rates volatility at the highest since the ECB last hiked rates.

“The macro push and pull should see any crush in rates volatility settle at higher average levels than seen in recent years,” said Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence. “The ECB hedged with a change of language on policy rates and made hikes data dependant rather than time based.”

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Next Week

It’s another big week for central bank action, with rate decisions due from the Bank of England as well as the Federal Reserve and Bank of Japan. All but one of the economists surveyed by Bloomberg see the BOE raising rates by 25 basis points to 0.75% Thursday. 

Also on Thursday, ECB President Christine Lagarde, Executive Board member Isabel Schnabel and Chief Economist Philip Lane will speak at a conference in Frankfurt.Sovereign bond supply should increase to 28 billion euros ($30.6 billion), according to Commerzbank AG, with auctions in Germany, Finland, France and Spain.German bond auctions include March 2024 notes. The country’s finance agency increased the volume of the bond earlier this month, following scarcity that it said was potentially down to some of the bondholders being sanctioned.

©2022 Bloomberg L.P.

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