Global Rates: Sovereign spreads, euro area rate vol and UK rates into the Budget

Francis Diamond (0:03)

Hi, and welcome to At Any Rate, JP. Morgan's global research podcast series, where we take a look at some of the drivers behind the biggest trends and themes across fixed income, currencies, and commodity markets. I'm Francis Diamond, head of European Rate Strategy at JP. Morgan. And today, I'm joined by my colleagues Aditya Chordia and Khagendra Gupta to discuss sovereign spreads in Europe, rates volatility, and some thoughts on UK rate markets into the budget.

So DM yields are lower over the past week, and mainly it's been led by treasuries reflecting some growing concerns over recent days over AIX valuations, while sovereign spreads in Europe have stabilized or modestly tightened as a technical and positioning backdrop, particularly in France, has improved.

So Aditya, how do you interpret the dynamics of sovereign spreads this week? It looks like 10 year France, Germany stabilized around about 140 basis points. I think this is now a new steady state level. And what about Italian spreads?

Aditya Chordia (1:00)

So thanks Francis. So indeed, as I mentioned, like in terms of spreads have stabilized over the past two weeks.

Although we do have some in committed choppiness, especially in France, but given the moves we saw of the sharp widening during late August, late September, early October, I think clearly the spreads have found a new steady stabilization level at the time being. And what I highlighted in the previous podcast, like the widening pressure through late summer into, let's say, early October, which we saw among the weakest sovereign credits. So I'm here, let's say France was the main one, but Italy, Greece and Belgium also widened in my space. And we have attributed this pattern to a combination of the resilient reason growth, which in turn led to a sharp rise in yields, along with the higher energy prices, and also elevated volatility, which disproportionately deteriorated the debt dynamics for the high debt issuers. And then on top of it, we had the renewed caution on France amid the expectation of choppy political news story. We had the budget slippages for 2026, the 2027 budget announcement, and ongoing chatter around the 2027 presidential election. Overall, as we discussed last time, there's not much new news over the past two months to warn such moves, but clearly the noise in an already uncertain period was adding to the, to the widening move. And finally, and I think that's the one which I stressed last time, is the technical and positioning headwinds, which were the key to have, especially during the last week of the widening, in the last week of September we saw.

And somehow, some of the, like this week, we are able to look at to the data which over the period, and we, the technical washout nature or interpretation is getting much more clearer when we look at, let's say, example, the yield versus spread relationship, which has evolved in a way, like it's clearly points that the late September, a good part was about technical washout. So what I'm trying to say here is that, like the spread sensitivity to higher-debt sovereigns or to the level of yields has been rising through late summer. So as the yields were increasing, the high-debt sovereigns were the ones which were writing the most, which as I discussed above, was more about increasing that system. Not concerns about that system, but challenges are increasing cost for the higher-debt countries because of the higher interest rate. So it disproportionately impacts them.

And that relationship sort of weakened dramatically around late September, because at that time, we saw German yields or even ECB tightening expectations getting eased, while the French spreads were widening aggressively. And that is consistent in our view with positioning or technical drivers temporarily dominating the fundamentals. And then, over the recent weeks, especially over this week, the direction has appeared to reassert itself in the sense that we have seen intra-immune spreads, especially even the French spreads, tighten alongside yield rally. And the rally over this week, as you also mentioned before, globally was driven by a bit more risk of nature around the AI, equity valuations, those type of concerns. And even in those risk of episodes, the intra-immune spreads and the French spreads were able to tighten as the yields were rallying. So that re-strengthening of the yield sensitivity suggests that the most acute technical pressures are behind us, and earlier the dislocations have likely faded. So leaving spreads once again more responsible for the broad rate move. So I think the technical picture is much more clean and loud. I think positioning, the sense we get anecdotally, is still heavy at the front end, but feels like it might be in a much more stronger or stable hands in France. So in France, as you mentioned, like it's just a new steady state, we still find the levels maybe a bit cheap, even when we look at different valuation frameworks and apply some judgment on the volatile discount that should be priced. But we believe that the ongoing risk of volatile noise, along with still elevated global rates for volatility, will keep investors a bit more cautious on France despite these attractive valuations. So even if there is room for 10-20 basis point, like from 140 we go closer to like say 110 basis point, 120 basis point level, that's what we have in our forecast. But it might be much more gradual, it might take a bit more stabilization before that thing is realized. Whereas we can start seeing some gradual normalization in other intermediary spreads, as these technical stress in the period is behind us and we see more stabilization. So those spreads who did widen along with France around that, periodically September are looking quite attractive. For example, Italy is now screening quite wide versus Euro-ID credit. So there could be quite interesting opportunities on those fronts.