- RBC told investors it had taken profits on a trade backing a tightening of the spread between 10-year U.K. gilts and German bunds, while taking outright short positions on the benchmark U.S. 10-year Treasury and U.K. 10-year gilt.
- Jefferies macro strategists supported this outlook in a note Wednesday, with U.S. economist Aneta Markowska projecting the U.S. 10-year will resume its climb to 2% by the end of the year, with risks building to the upside.
In a note Wednesday, RBC told investors it had taken profits on a trade backing a tightening of the spread between 10-year U.K. gilts and German bunds, while taking outright short positions on the benchmark U.S. 10-year Treasury and U.K. 10-year gilt.
To short a government bond is to open a trade that profits if the price of the bond falls, effectively betting that yields will rise.
This has been a key focus for investors in recent weeks as the prospect of global economic reopening and a potential uptick in inflation prompted concerns that central banks may look to wind down their unprecedented monetary policy support.
The U.S. 10-year yield continued to rise on Wednesday, climbing to 1.6324% by late afternoon trading in Europe. RBC Global Macro Strategist Peter Schaffrik said this trend was now here to stay.
Reopening fears subsiding
Schaffrik suggested that the gathering speed of Covid-19 vaccinations in Europe would assuage concerns about the broader economic reopening, while warmer weather in the Northern Hemisphere would see social activity shift outdoors, keeping virus caseloads lower even as restrictions are eased.
"Despite the worrying reports about mutations of the virus, the risk of this development delaying the re-opening has been priced to some degree already," Schaffrik said.
"Meanwhile, there are also first signs that some of the vaccines being used (particularly the mRNA vaccines used predominantly in the US and EU) might be more efficient against the new strains than previously feared."
While this would allow developed markets to re-open, it will continue to necessitate strict travel controls with many emerging markets which are struggling with renewed outbreaks and vaccine shortages, Schaffrik said.
"This dichotomy is likely to accentuate the demand/supply imbalances even further with key raw materials likely to be short in supply for longer than previously anticipated, whilst demand from re-opening DMs is picking up," he continued, referring to developed markets.
"This could, in turn, accentuate and elongate supply-driven price pressures more than previously thought."
Furthermore, uncertainty about the European recovery fund has lifted, which should enable the EU to support the recovery from the third quarter onwards, Schaffrik suggested.
In market terms, RBC assessed that momentum toward lower yields is fading along with the momentum toward U.S. and U.K. outperformance versus Europe, which is manifesting itself in a mellowing of U.S. 10-year and U.K. yields while bunds buck the downward trend.
With central banks beginning to send hawkish signals, most notably the Bank of Canada last week, RBC believes it is unlikely that the U.S. Federal Reserve or the European Central Bank will pull away into bond market bullish stances.
Schaffrik said the Bank of England, which meets next week, will likely shift the debate toward tapering and normalization, a slightly hawkish pivot.
"Overall, we therefore think that risk reward is skewed towards a resumption of the trend prevailing earlier this year," Schaffrik concluded, meaning the implied market narrative of re-opening that goes hand in hand with higher bond yields and steeper curves.
"In fact, we think with the central bank debate shifting towards easing of support measures through tapering, this could drive another leg higher in bond yields."
Jefferies macro strategists supported this outlook in a note Wednesday, with U.S. economist Aneta Markowska projecting the U.S. 10-year will resume its climb to 2% by the end of the year, with risks building to the upside.
"The kind of recovery currently built into the price is a roughly 6-6.5% recovery followed by 3% growth next year, with the labor market returning to full employment by mid/late 2022," Markowska said.
"We are more bullish on the economy with 5% GDP in '22 and a return to full employment by year-end."