Analysis: Curves to flatten further as long yields fall

By Kirsten Donovan

LONDON (BestGrowthStock) – A fall in euro zone long-dated rates, which has seen curves flatten sharply, has further to run as investors are forced to lock in longer-maturity returns in the face of a deteriorating global economic outlook.

Worries about a double dip recession in the United States means the risk aversion trade is back in full swing, pushing share prices lower and supporting government bonds.

With short yields anchored on the view official U.S. and euro zone interest rates will stay low, investors and speculators have been driven to longer-dated bonds and interest rate swaps to generate a return, flattening yield curves.

Ten- and 30-year German bond yields have hit record lows in recent sessions and 30-year swap rates are at their lowest since December 2008 after a spate of weak U.S. and Japanese economic data and since the Federal Reserve resumed Treasury purchases.

It is not just a euro zone phenomenon. Long-dated U.S. rates have also fallen sharply, partly due to demand from Japanese investors hungry for more than the multi-year low returns offered by Japanese government bonds.

“It’s very likely that the long end of the curve will flatten further,” said BNP Paribas rate strategist Matteo Regesta, adding flows from funds seeking to cover their liabilities and from speculators were making the curve flattening “a self-fulfilling kind of event.”

As well as speculative flows, fund managers such as those running pension investments are among those driving the moves, as they seek to lock in longer-term sources of income.

Funds must balance the duration of their assets and liabilities to reduce exposure to interest rate risk and match the present value of their assets and liabilities. The lower prevailing interest rates, the greater the present value of any liabilities.

“The pain trade for a pension fund asset manager is falling rates and low equities,” Regesta said.

Thirty-year German bond yields have fallen as low as 2.644 percent, with equivalent swap rates touching 2.54 percent, just two basis points above the lows hit in December 2008 as the financial crisis took hold.

Interest rate swaps offer an alternative to buying bonds, providing a fixed income stream, without the need to purchase the underlying asset.

“A limited supply of unquestionably risk-free euro denominated assets is meeting with potentially overwhelming demand from banks, life insurers, pension funds and foreign reserves managers, be it for regulatory or for safety reasons,” Commerzbank analyst Christoph Rieger said.

The move has flattened the 10/30 year swap curve more than 15 bps to around 30 bps over the last two weeks. Analysts say it could easily settle around 20 basis points but a repeat of late 2008, when that section of the curve inverted by around 50 basis points, is not expected as the whole curve is flattening.

“The flattening we’re seeing is incredible but the 10/30 is not moving unilaterally. 2/10s are keeping up and it’s part of an overall flattening process,” said ING rate strategist Padhraic Garvey.


The risk aversion of recent days means European shares (.FTEU3: ) are close to their lowest levels in a month and down almost 10 percent from the highs of mid-April.

The direction of the 10/30 euro zone swap curve and European shares are strongly correlated. BNP Paribas said it was 0.9 in the three months to mid-June, although it has dropped to around 0.6 as flows from funds seeking to receive fixed rate payments have yet to catch up with moves in equities.

Analysts say that means a clear reversal of risk sentiment will be necessary to halt the recent curve flattening.

“As long as risk aversion dominates sentiment, the current trend cannot be challenged,” BNP’s Regesta said.

Analysis: Curves to flatten further as long yields fall