Lombard Odier is shortening the duration of European government bonds in its £2.5 billion global fixed-income portfolio, 80% of which is government bonds, and has just begun to sell off positions in five- to seven-year German and French government bonds. London-based Steven Murphy, senior investment analyst, says the firm will add to its positions in 30-year Spanish and Italian government paper to capitalise on their relative cheapness versus German bunds, but will maintain the majority of the portfolio in cash, thereby keeping duration short. Italian and Spanish 30-years were trading at about 20 basis points over 30-year bunds recently, but have since gapped out to 35-40 basis points over. Once there is a sustained recovery in the global equity markets, which Murphy considers to be the leading indicator of an economic recovery, the firm plans to buy in the three- to five-year range across the board in Europe's so-called core markets.
Murphy says his firm is not as confident as the rest of the market appears to be on how far the European Central Bank will cut interest rates. "The market is a little carried away with what the ECB will deliver. It has a different mandate to the [U.S. Federal Reserve] and is not as activist. It's much more focused on inflation," notes Murphy. Currently, three-month Euribor strips are at 2%, whereas Lombard estimates interest rates will be about 3% in three months time. And, whereas Euribor strips appear to indicate short-term interest rates will be about 3% by mid-next year, Lombard predicts a sharper reversal to 3.5%. Accordingly, Murphy says three-year bunds should yield 4.25% in 12 months, up from roughly 3.20% last Tuesday, making them a good trade versus the 30-year bunds, which should be at about 5.5%, in contrast to 4.93% last Tuesday. Lombard Odier benchmarks its assets against a variety of indices.