Market News

(Bloomberg) -- There’s a near €2 trillion ($2.3 trillion) upheaval coming for European bond markets to cap a 2025 already marked by tariff twists and turns, deficit worries and now a political crisis in France.

The storm is centered on a long-planned reform of the Dutch pension system, the European Union’s biggest. It’s already pushing up yields on longer-dated bonds and traders are positioning for volatility in the euro swaps market, which the funds use for hedging. Things could become more extreme at the turn of the year, when a large tranche of funds are set to transition, due to lower liquidity at that time.

The Dutch central bank warned earlier this year of a risk to financial stability, and the complexity of the underlying mechanics means it’s hard to get a grasp on the extent of any disruption.

Asset managers including BlackRock Inc. and Aviva Investors are recommending caution when it comes to the long-end of the yield curve, favoring shorter-dated tenors. For others, including JPMorgan Asset Management, the issue is helping to make US Treasuries look more attractive than European government bonds.

“There are so many unknowns and moving parts,” said Ales Koutny, head of international rates at Vanguard. “Everybody knows that the event is there, but nobody knows what the final outcome is going to be. Everybody’s just trying their best to position for it.”

The revamp is intended to help cope with an aging population and changing labor market.

While the Netherlands accounts for just 7% of the euro-area economy, the pension system is an outsize market player. It has more than half of all pension savings in the bloc, according to European Central Bank data. Its European bond holdings total almost €300 billion.

Volatility

In recent weeks, a gauge of future volatility in 30-year euro swaps has picked up, which ING Group NV strategists say is partly down to the transition. The shift is also affecting euro funding costs.

These ripples stem from changes in the way Dutch retirement funds protect their portfolios against fluctuations in interest rates. Until now, they’ve relied heavily on long-dated swaps to ensure they have enough cash to pay pensioners down the line, irrespective of what happens to borrowing costs.

Under the switch to so-called life-cycle investing, younger workers will be more heavily invested in riskier assets like stocks, with less need for these long-dated hedges. Older members’ savings will be skewed toward safer securities like bonds, but the corresponding hedges will also shorten.

About 36 funds are scheduled to switch to the new system on Jan. 1, with the rest following in tranches every six months until January 2028. With the first big wave seeking to unwind their hedges en masse at a time when liquidity is typically poor, investment banks and brokers may struggle to match up sellers and buyers, gumming up the system.

The supply-demand imbalance for longer-dated swaps is already significant. With a pipeline of pension funds needing to unwind swap positions, market players such as hedge funds seeking to profit could let this play out before stepping in to take the other side of the trade. That could lead to a rapid steepening in the curve, said Rohan Khanna, head of European Rates Research at Barclays Plc.

How it unfolds in January is “anybody’s guess, but the nervousness is going to be very high,” Khanna said. “The market can become illiquid or jumpy in such situations.”

Complicating preparations is a political crisis in The Netherlands, where there will be a snap election after the collapse this summer of both the government and a caretaker administration that followed it. Among those that quit was Social Affairs Minister Eddy van Hijum, who was in charge of the transition.

He was expected to give pension funds an extra year to reduce their interest-rate hedges once they’ve transitioned. That plan is unlikely to be affected, though a parliamentary debate on pensions scheduled for this week might be postponed, a spokesperson for the ministry said.

Debt Demand

There’s also a question over what this turn-of-the-year move will do to demand for long-dated debt, with January typically one of the busiest periods for new bond sales.

Yields on German and French 30-year debt have risen for the past four months and are trading close to multi-year highs as fiscal tensions ramp up. France has been thrust into yet another political crisis over its budget, and the government may be toppled this month.

ABN Amro estimates that the pension sector's largest exposures are in German, French and Dutch debt, and the drop in demand may put pressure on governments to switch toward shorter maturities, according to strategists including Sonia Renoult.

That could leave them more exposed to interest-rate volatility as they are forced into refinancing their debt more frequently.

Investors like Steve Ryder, who helps run €8.3 billion in fixed income assets at Aviva, say they’ll avoid any exposure to longer-dated European bonds at the end of the year, given the likelihood for choppiness.

“If everyone transitions at the same time it would become a bit of a hot potato for the dealers that have to take on the risk,” he said.

There are some mitigating factors. Pension funds may start to unwind long-dated hedges ahead of time, reducing the risk of bottlenecks, if they’re confident they’ve got enough of a buffer to absorb potential losses.

There is also the one-year adjustment period the government is granting for hedges. However, the longer pension funds take, the longer they would be over-hedged, which is particularly relevant for younger workers.

The Dutch central bank said it will continue to monitor the transition but is confident that the one-year period “provides pension funds with sufficient flexibility to adjust their portfolios in an orderly manner.”

Many trading desks remain anxious and expect things to move quickly at the turn of the year.

“We still think the transition will be front-loaded,” said Pierre Hauviller, director of pensions and insurance structuring at Deutsche Bank AG, adding that markets are positioning for this. “Volatility trades in early January are already very crowded.”

--With assistance from Patrick Van Oosterom.

(Updates with additional detail on moves in long-term yields.)