Market Analysis - Bond Markets Take Center Stage

 | May 15, 2014 05:24AM ET

h2 Bond Markets Take Center Stage

The action yesterday was in global bond markets as yields in the UK, Germany and the US slid to 2014 lows. The Bank of England’s inflation report was less hawkish than many had expected. The inflation forecasts made on the basis of market interest rates showed inflation slightly below target in two to three years’ time, which suggests that the Bank has room to raise rates at a slower pace than the market expects. UK bond yields fell across the curve as a result (10-year yields down a sharp 10 bps), and as for GBP/USD, the assault on 1.70 is on hold for now, although the technical picture still looks bullish; see below for EUR/GBP.

On the continent, both core and peripheral bond yields fell as the market continued to price in an easing of monetary policy at next month’s ECB meeting. ECB Executive Board member, Yves Mersch, yesterday confirmed that ECB President Draghi’s comment about the ECB being “comfortable” moving in June was a coded statement meant to convey to the market that a change in policy was imminent, while Executive Board member Praet told Die Zeit that the ECB is considering a range of policy measures including new long-term refinancing operations (LTROs) and cutting rates into negative territory. Ten-year Bund yields declined by 5 bps to the lowest level since the talk of the Fed “tapering” began last year.

Even US bond yields joined in the global rally despite US producer price inflation hitting a two-year high in April. The 10-year note was down 7 bps while Fed Funds expectations collapsed 7.5 bps in the long end.

The FX implications of this global bond market rally are clear: carry is king and EM currencies should be doing better as the rally take the pressure off these countries to raise rates. For example, RUB was the biggest gainer over the last 24 hours despite the worsening situation in the Ukraine, which the Russian Foreign Minister has characterized as “as close to civil war as you can get,” which doesn’t seem like an exaggeration. In the emerging market space, this would tend to favour TRY, RUB, INR, IDR, ZAR, BRL, although clearly there is more than just interest rates to worry about here; TRY was the weakest of the EM currencies we track over the last 24 hours, while I would not recommend RUB at this time for obvious reasons. In developed markets, NZD, AUDand NOKwould tend to be the beneficiaries of increased emphasis on carry, although personally I question the sustainability of any AUD rally.