20th August 2014
Michael Krautzberger, Head of European Fixed Income at BlackRock, comments on German 10-year Bund yields crossing below 1% and provides some graphs for his analysis too.
German short-dated yields have been low for several years. Last week saw German 10-year Bund yields cross below 1% for the first time. Understandably this raises questions over what is happening in Europe and why yields have gotten so low. However, it’s important to remember that low yields in Europe are not a new phenomenon. Safe-haven flows during the euro area sovereign debt crisis, central bank emergency liquidity measures, and most recently, the ECB’s negative deposit rate have worked to depress short-maturity yields in Germany (and other core euro countries) for several years. The 2-year Schatz initially slipped below 1% back in February 2010 only to dive again in August 2011, from which it has not re-surfaced. German government bond yields are de minimis, even negative at times, out to 3-4 years in maturity.
Does a 1% Bund mean deflation? Since the start of 2014, German 10-year bund yields have steadily fallen from 1.9% to the precipice of 1%. Almost two-thirds of the drop in bund yields since January is due to weaker growth expectations, while one-third relates to falling inflation expectations. This important distinction can be seen in Figure 2 whereby 10-year inflation-linked bonds inGermany have led the decline lower as inflation break-evens remained relatively stable. Germany (and most of the euro area) experienced a deceleration in growth during the second quarter. This cyclical downturn, exacerbated by geopolitical risks and the impact of trade sanctions with Russia, creates even greater downside risks for second-half European growth. As yet, however, this is a different proposition than outright deflation, in our opinion.
Euro area deflation is still not our base case scenario
“Though the euro area remains susceptible to disinflationary risks, outright Japan-style deflation is not our base case scenario. An accumulation of external imbalances and diminished competitiveness were major factors behind the European sovereign debt crisis. Part of the healing process involves intra-euro area relative price adjustments. At least so far, that process has occurred by falling prices and wages in the peripheral countries; this need not be the case going forward. This so-called ‘internal devaluation’ explains some of the weakness in headline euro area CPI. As seen in Figure 4, longer-term inflation expectations remain relatively stable, at least for now. In addition, the Japanese deflation experience involved a slow monetary policy response; a mistake that the ECB has vowed not to repeat. In fact, the weaker GDP and inflation data might increase pressure on the ECB for a stronger policy response and help the rebalancing. We are not willing to bet against the ECB doing whatever is necessary to avoid Japanese-style policy mistakes.
What does it mean for Fixed Income investing in Europe?
The euro-denominated (and global) fixed income investment universe is much broader than just German Bunds. Bunds may only yield 1%, but the average yield of a 7-10-year investment-grade, euro-denominated bond is still higher (1.5%). More importantly, there are plenty of bonds yielding well over 1.5% in the euro area. Spain and Italy for example are trading above 2.5% and 2.6% respectively. And why stop at Europe? Global fixed income offers an even richer yield universe (Figure 5). Japanese bond investors did not have this diversification potential in their domestic currency when JGB yields went below 1% at the beginning of the last decade. While we see little value in Bunds relative to other European sovereigns, even at these low yield levels Bunds will continue to play a role in European portfolios as a safe haven instrument and risk diversifier.
The reality of a 1% Bund yield highlights the importance of giving managers flexibility on how to allocate capital within today’s fixed income markets. Investment mandates that move away from traditional benchmarks allow more active asset allocation within fixed income. Active managers in unconstrained strategies can employ duration and dynamic spread sector allocation to augment total returns. Investing using a relative value approach can take advantage of opportunities between European sovereigns but also versus corporates and global sovereigns such as the US or the UK is increasingly important.