EUROPE - Barclays Capital expects a slowdown in market momentum and two rate hikes from the European Central Bank (ECB) before the autumn as inflation worries take hold among monetary authorities and investors.
But while research from its latest quarterly global outlook suggests longer-term benchmark yields will absorb these rate hikes and trade in a range, it identifies opportunity in the consequent widening of German bund asset swap spreads.
After being overweight risk for the last two years, Barclays Capital is now urging caution.
Larry Kantor, head of research, said: "It's not that we are advising investors to shun risky assets, but we find we are moving into a period where markets will be less trending and more choppy. The key difference is that the environment now includes inflation pressures and expectations for policy tightening."
Kantor pointed to fiscal tightening across Europe and predicted monetary tightening close on its heels. His colleague, head of European economic research Frank Engels, noted that the ECB had surprised the market by turning "really hawkish", and called for a 25 basis point hike in April followed by another in June or July.
But Engels also pointed out that rising rates were a threat to struggling euro-zone peripheral economies, and that they did not appear justified by current core inflation or monetary growth statistics.
He suggested the ECB might be focusing more on headline inflation as a recognition that there had been "structural change" to pricing in commodities markets under demand pressure from emerging economies, which could lead to core inflation in Europe, imported through higher unit labour costs in those emerging economies.
Given this more unorthodox approach to inflation control, Barclays Capital anticipates a 'slow-and-steady' series of hikes.
"This is why the bank will stop after two hikes, to see how this normalisation will affect the peripheral European economies," Engels said.
The effect on longer-term rates should be muted, but Barclays Capital does anticipate that rising short-end rates will lead to the German bund swap spread widening, particularly at the 10-year point on the curve.
The bank observes that when bond yields rise due to priced-in or realised rate hike expectations, swap spreads widen - because deficits tend to narrow and the growth outlook improves during rising rate environments.
IPE asked Barclays Capital rates analyst Cagdas Aksu how this trade might be affected if European pension funds that use the swap curve to discount liabilities decide to unwind some of the trades they put on in early 2009, when the swap spread was negative.
At that time, many sold their LDI swaps in exchange for the extra yield available from cash market bonds. As the spread continues to widen, are they likely to reverse the trade to lock in better rates from the swaps?
"Our swap spread widening view (bonds outperforming versus swaps) is in the 10-year part of the curve," Aksu replied via email. "Any pension fund buying of spreads in early 2009 is most likely to have happened in the ultra long end of the curve (30-year maturity)."
However, that does not mean he sees no scope for spread widening at the long end. He pointed out that pension funds were trading when spreads were at distressed levels, and that while those spreads are now slightly positive again, there is still "more widening room" for ultra-long swap spreads.
"I don't think funds that bought these spreads at distressed levels will be in any rush to get out any time soon," he wrote.
One risk to holding these positions would be an upward drift in bund yields associated with the contingent liabilities assumed by Germany in the EFSF/ESM mechanisms.
But Aksu noted that this risk was likely to be focused on the more liquid, near-end of the curve.
"Quite a bit of this is already mostly likely to be in the price for the 10-year sector," he wrote.
"As such, recent market reaction on the back of announcements coming out of this month's EU Summits have already been in support of our view (spreads have held in very well despite officials agreeing to increase the effective lending capacity of the EFSF)."