Eurozone: Front-end break-evens to widen further - HSBC

Theologis Chapsalis, Strategist at HSBC, suggests that Eurozone’s widening momentum in front-end break-evens is likely to continue, especially across non-core markets.

Key Quotes

“Retail gasoline prices both in the Eurozone core and non-core are now up in annualised terms and upcoming base effects pave the way to higher headline inflation numbers. Moreover, Eurozone core inflation has never fallen below 0.6%, so front-end break-evens in the 70-90bp territory are still cheap, especially if we take into account rising inflation and positive carry until March.”

“To some extent, the December ECB meeting has been a game changer for linkers. The broadening of asset purchases below the depo limit means that the richness of front-end Bundeis cannot continue. Five-year nominal yields have been below -0.4% for most part of the last six months and there is clearly some catch-up buying necessary, which all else equal should make ASW iota spreads wider. Against this backdrop we see better value in non-core break-evens and especially BTPei18, BTPei22 and SPGBei19 which are attractive in seasonally-adjusted break-even (SABE) terms. This part of the curve should benefit from a softer euro. While the euro is still up 4% in yoy terms, it has weakened by about 3.5% since the US elections due to dollar strength. And if this trends continues, then the market will have to re-price higher any short-dated Eurozone inflation.”

“…but not the long-end

By contrast the potential upside for the long-end is limited given the move which we have already experienced in the wake of Tumpflation and its spill-over to the Eurozone market. True, the steepening of nominal core curves can be seen as the bellwether of higher inflation forwards, but we believe that without structural changes even if inflation forwards rise, then this will not be sustainable. Therefore at current levels we prefer adopting a bearish stance towards inflation forwards such EUR 5Y5Y.

On the issuance side, we would expect both Bundei46 and OATei47 to be re-opened in the coming months and the current break-even levels make re-openings attractive for issuers. Therefore, we believe there exists an implicit cap on how wide long-end BEs can become.  The steepening of the inflation swap term structure has happened at a time of rising oil prices and we expect some flattening to follow.”