Gilt Yields Hit Record Low As Case Builds For More Qe

• 10-yr gilt yields fall to a 300-yr low and 2-yr German bonds hit zero as euro crisis intensifies
• Sharp fall in manufacturing PMI puts QE back in the frame for Thursday’s MPC meeting
• But ECB likely to hold off further stimlus until after the Greek elections

The flight to haven assets has entered a new phase over the past week, as the unfolding drama in the euro area has dominated sentiment. While the UK celebrates the Queen’s Diamond Jubilee this weekend, the focus on overeigns is taking on a very different shape on the continent. Earlier hopes that the crisis might just be confined to Greece have been severely dashed, as the problems in the Spanish banking system - and the growing prospect of  Madrid having to tap EU bailout funds - have prompted a new wave of contagion. Spanish 10-yr bond yields have surged, pulling the spreads of other Southern European states sharply higher.

Peripheral spreads across Europe are now at levels where additional margin requirements and haircuts set by the London Clearing House (LCH) threaten substantial liquidations. It was these liquidations that ultimately forced the hand of Ireland and Portugal to seek EU funds. So far, Spain has refused to countenance drawing on external aid, mindful of the cost of effectively relinquishing its fiscal sovereignty. However, if yields rise much further - 7% is viewed as a pivotal threshold - it may not have much choice.

Overlaying this, significant uncertainty remains over the Greek election on 17th June and what the result may mean for Greece’s euro prospects. Latest pol ls indicate that the pro-austerity conservatives (New Democracy and Pasok) and leftist parties (led by SYRIZA) are broadly level pegging - raising the prospect of another hung parliament. The failure of any one party or group of parties to win a clear mandate on the 17th would almost certainly heighten the sense of crisis- not just in Greece but across the region. The onus remains on the Troika to take clear and decisive action, either one way or another, although markets are understandably sceptical that such clarity will be forthcoming.

With euro event risk running extremely high, and the downturn in Europe showing renewed signs of spreading across the globe, there has been a significant flight to safety. In the UK, 10-yr yields are now the lowest they have been since 1703. In a similarly extraordinary development, 2-yr German yields have dropped effectively to zero.

Against this backdrop, the economic data have taken a distinct turn for the worse. The plunge in the UK manufacturing PMI in May and the weakness of the latest US Employment Report have only served to reinforce concerns that the crisis in the euro area has global ramifications. Indeed it is not only the western economies where growth prospects are flagging. The sharp
dip in India’s GDP growth in Q1 and weaker manufacturing data in China provide worrying signs that the slowdown is spreading to Asia.

Looking to the coming week, the extended Diamond Jubilee Bank Holiday is likely to come as welcome relief. Although the domestic economic data calendar is relatively thin, the services PMI and the BoE MPC meeting will attract keen interest. If, as we suspect, the services PMI echoes the weakness in the manufacturing PMI, it could pave the way for another £50bn of QE when the Bank of England meets on Thursday. Although the MPC could decide to hold off until the Greek elections, given the pace at which economic and financial market confidence are deteriorating, we see little reason to delay.

The ECB is also due to meet on Wednesday (a day earlier than usual because of the Corpus Christi holiday). Arguably, the same case could be made for further stimulus from the ECB. Given
the heightened political dynamic in the euro area, however, we suspect the line of least resistance is for the ECB to keep policy unchanged - at least for now.

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