Beware: Gilt yields can’t fall forever – RBC CM

Research Team at RBC Capital Markets, remain of the opinion that it is not worth chasing the rally in core bond markets.

Key Quotes

“In fact, when just looking at Bunds and USTs it is hard to make out a bullish trend in their own rights. USTs hover just under 1.60% and upon a break might well trade back towards 1.80%. We also stipulate that the Bund market’s performance is actually rather underwhelming given the Gilt performance in comparison.

In fact, just comparing nominal bond yields is very misleading as inflation expectations and real growth rates can vary substantially. And in fact, this is precisely what the table shows. For instance, in the case of Japan, real bond rates are actually fairly high – for the simple fact that inflation expectations are very low. Furthermore, with the expected growth rates very low, the actual policy accommodation is minimal - which can be interpreted as one reason why Japan's monetary policy fails to stimulate the economy. A similar observation can be made in the case of Italy – although for different reasons: The nominal rate is simply too high, the highest in our small sample. This is something that can be remedied easier by the ECB. What is striking is, that the case of the UK sticks out quite substantially: Not only are real yields the lowest across the field (due to the relatively high inflation expectations). Also the measure of policy accommodation is by far the largest as the expected trend growth rate remains relatively high by most measures.

What does one make out of this? It certainly does not guide short term trading, but an observation like this should caution about simply expecting Gilt yields to keep falling until, say, they reached Bund or JGB levels. The valuation metric remains different and thus current Gilt yields should already flag up as expensive in relative terms.

We equally see not enough value in Bunds at current levels, while UST remain more interesting only if the economy falters and even more stimulus is required - which seems unlikely. We thus would reduce risks in these core markets and see the best risk/reward in peripheral European markets. This should also be helped by our firm belief that the EUB will have to adapt their buying metric in the QE programme and move away from the capital key to some measure, such as a volume weighted key, which would see more Southern European buying.”