Get the latest updates as we post them — right on your browser

. Last Updated: 07/27/2016

Bond Market Expected to Rally

LONDON -- Last month's heavy selling of government bonds by speculative funds may have left the markets better underpinned and ready to resume their rally, analysts say.

"We feel the deleveraging of the markets has transferred bonds from fickle speculative hands to long-term holders," said Mark Capleton, international bond strategist at Barclays de Zoete Wedd in London.

"We think European markets are much more firmly based now and we feel positive from here," he added.

"I totally agree with that," said Astrid Vogler, head of the Frankfurt office of Oechsle International Advisors. But she added some words of caution.

"No one knows how much the hedge funds still hold and I'm not sure we've seen all the selling yet. So I wouldn't be surprised in the next two to three weeks to see further hurdles," she said.

"But when this selling is over people will look back to fundamentals. People who buy bonds then will be more long-term investors," Vogler added.

Governments issue bonds to plug the gap between their revenues and their spending, and yields move in the opposite direction to bond prices. Bonds also help governments control inflation by taking liquid funds out of circulation for the period of the bonds' maturity.

Hedge funds such as Hungarian-born financier George Soros's Quantum Fund are aggressively managed pools of private money that take massive positions in global currency, bond and stock markets in search of large and quick profits. This year they have suffered nasty losses as bond markets beat a rapid retreat after a tightening of U.S. interest rates and the yen suddenly rose after the failure of U.S.-Japan trade talks.

Analysts still agree that further interest-rate cuts by the Bundesbank are needed before any bond rally can gather strength. And Tuesday morning's German repo rate cut was seen as a helpful step even though European bond prices eased back after it.

The lowest-accepted rate at the Bundesbank repo was 5.97 percent, down from the 6 percent seen since early December.

"The three-basis-point fall was roughly in line with expectations," said Capleton at BZW. "But we have seen signals in the last few days from various sources that rates can come down."

Lower short-term interest rates could lead to steeper yield curves in the government bond markets as prices of short-dated issues outperform those at the long end, with longer maturities.

"The German yield curve will probably steepen a bit," said Tony Childe, institutional futures broker at Mees Pierson Derivatives in London.

"I think short rates still have room to go lower, so we'll see a steepening of yield curves," agreed Vogler.

But Ian Blance, fixed-income economist at Nikko Europe in London, is not so sure. "We've probably had most of the steepening ... Once retail buyers are confident enough to come back in, they should be buying the long end again," Blance said.

And Vogler also tips the long end to maximize duration as yields fall back. Longer-dated, lower-coupon bonds have higher duration, meaning their prices move more sharply in response to an overall change in yield levels.

Blance is not so sure that bonds are now in safer hands.

"We don't know whose hands they're in. But as long as they're not in the hands of the hedge funds they're okay. Most of the institutions we talk to agree with us there's value in the European markets," he said.