20th March 2015 by Chris Iggo
It’s a wild ride to lower yields. Maybe the end game is yields of -20bp across core markets in Europe, peripheral spreads of 20bp-30bp over Germany and Treasury and gilt yields at new lows. Sounds implausible? Nothing is these days in fixed income. In reality, we are not that far away and another year of high single digit total returns in bonds would deliver those kinds of levels. Then what? Will QE work, will inflation and growth be stronger or will the next leg be an intensification of the “currency war”? It could all end ugly if the US starts to talk down the dollar or if QE doesn’t deliver and there is nothing left in the monetary tool box. A major market meltdown might eventually force politicians to look at fiscal policy as the only way to boost real incomes, investments and jobs.
Across the zero line – A lot has happened since I last wrote my last note. The European Central Bank (ECB) has actually started its QE purchase programme. The Federal Reserve (Fed) has removed the word “patience” from his communique. The whole German yield curve is now below that of Japan. George Osborne delivered a pre-election budget in the UK and Manchester United actually played well. While the theme of monetary policy divergence remains a key focus for bond market investors, the last few weeks have proved how difficult it is for the Federal Reserve and the Bank of England to break away from emergency interest rate levels when the rest of the world is still easing amid concerns about further disinflation and the tepidity of growth. For a brief period from early-February to early-March, long term yields in the US and UK did increase but as soon as the ECB came in and forced European yields lower still, there was a pretty abrupt turnaround in Treasuries and Gilts. When 10-year Italian government bond yields were driven 100bps below US Treasury and Gilt yields the asset allocation response to those higher yielding markets was pretty swift. QE is continuing to lift all boats.
The Eurosystem is absorbing the risk premiums – The short term momentum is difficult to fight. During our quarterly forecasting meetings this week it was pointed out that when the Fed and the Bank of England (BoE) were doing QE, central bank purchases were around half of new net issuance by the US and UK governments. For the ECB, on the other hand, QE purchases are expected to account for more than double net issuance. The stock of Euro denominated debt held outside of the ECB will actually decline, compared to remaining roughly unchanged during the US and UK episodes. With the universe of government bonds becoming smaller as more of the stock of debt moves to negative yields, the impact of the ECB’s actions will be for further curve flattening and even lower yields. One can take the view that these moves are entirely technical and reflect the supply and demand dynamics. Or one can rationalise them by arguing that there does not need to be a term risk premium in the Euro curve because the ECB won’t raise rates for a generation. Furthermore, there does not need to be a sovereign risk premium either because QE means the Euro will never fall apart and there is de facto socialisation of debt within the single currency. Or put more bluntly, Italian credit risk is the same as Germany.
Giving up on higher yields? – We are only a week or so into the actual buying program so this momentum is likely to continue interrupted only by bouts of government bond supply that both puts the ECB on hold for a day or so at a time and allows European banks to reposition themselves for the next bout of buying. The peripheral bulls will also make the point that there will be a huge fiscal windfall from lower yields which helps the fundamentals and the growth outlook. In addition to the general trend of lower core yields and narrower peripheral spreads, the asset allocation/portfolio rebalancing impact of QE will continue to be seen. This means a weaker euro. (Expect to see more American tourists in Rome, Paris, Amsterdam and elsewhere this summer as euro-dollar trades below parity). It also means other asset classes perform, including high yield (+2.78% year to date total return for Euro high yield) and equities. It has not been so clear for investment grade credit in Europe. The total return looks decent but investment grade has underperformed government bonds since the ECB started buying. This is not surprising. For one thing the central bank is buying government bonds in size. At the same time corporate issuance has increased significantly. The issuance has come from European companies locking in all time low borrowing costs and from US companies taking advantage of cheap Euro funding. So spreads have widened and this may continue. Corporate issuance is unlikely to make up the shortfall created by the ECB’s hoovering up of debt, especially in terms of duration, but it will help investors. On the subject of asset allocation/re-balancing, I have already alluded to flows into gilts and Treasuries, which are likely to be compounded by money flows from Japan after the end of the current fiscal year. So in the event that the Fed and the BoE continue to prevaricate on the inflation / rates outlook, yields may head even lower. Oh, and by the way, for those of you interested in property markets, more than one mention was made during our forecasting meetings of a potential developing bubble in German real estate. Money has to go somewhere and a castle on the Rhine is as good a place as anywhere. If rising asset prices make Europeans invest and spend, then QE will have done its job. If.
Until that CPI spices up – It is clear what would cause a turnaround in global bond markets. It would be a marked turn in the inflation trend and this is looking as far off as ever. Oil prices have moved lower again over the last week, driven by reports of reduced storage capacity in the US. There is little sign of price pressures in the pipeline in the major G7 industrial surveys and broad wage growth remains elusive. That prevarication by the Fed and the BoE will continue until there are these signs of inflation picking up, or at least a rise in market inflation expectations. For the Euro curve to steepen it would require that these global growth/inflation signals become very strong – strong enough to cause further upward revisions to the European growth and inflation outlook sufficient to bring about a conclusion to QE in 2016. Without all of that, the path of least resistance is lower bond yields (forecasting the potential for lower bond yields and buying bonds with negative bond yields are two very different things, I hasten to add).
$8 for a Bud in NY or €8 for 1664 in Paris…parity for the euro seems right then – where to drink beer this summer? – The other aspect to global monetary profligacy is the so-called currency war. The Euro area must be broadly welcoming the depreciation of the single currency against the dollar and the trend in emerging markets is to talk/force down the external value of many currencies. We’ve seen the Swiss, Danish and Swedes take action to prevent currency strength and some UK commentators have warned about the deflationary impact of the rise in the UK trade weighted exchange rate. So far the US has been relaxed although one suspects that references to “international conditions” in many Federal Open Market Committee (FOMC) communiques represents a coded concern that the strong dollar could prevent the Fed from meeting the macro targets it sees as being necessary for a hike in rates. A more blatant stance against a strong dollar from Washington would be a bad sign for global markets, bringing higher volatility to rates, credit and equity sectors. Experience tells me that if the US is dragged into a currency war, the yen and the Swiss franc are still probably the safest currencies to hold. Realistically, with the unemployment rate where it is and with an election on the horizon, I doubt Washington wants to drag the dollar down just now, but watch this space if we go through parity versus the Euro and towards 150 yen and the US data softens, things may very well change.
And now for the gloomy bit – With all of this in mind how should we navigate through the bond markets? It should be no surprise that I think everything looks very risky on a medium term view. QE has lifted all boats and one day the tide will go out. Most people think that 10-year Bund at 0.17% yield is ridiculous and a terrible investment proposition. The problem is we don’t know how long it will be before we can say “I told you so”. My feeling is that we are at risk of being in a period of economic and financial moribundity (from the Latin, being in a state of dying). Growth is slow, inflation is low, labour markets are not seeing enough dynamism to generate real wage growth, policy is failing to address the productivity deficit, the financial system remains silted up and will stay that way as banks and insurance companies deal with reduced margins between assets and liabilities and regulation bites further into risk taking. Meanwhile geo-political lunatics scare us. In the land of deflation the 1 basis point bond might be king. So when I can still get 6% in the US high yield market and 4.0% or more on European high yield bonds and probably still get paid for participating in the perpetual optimism of the equity markets, then that is where the risk budget should be spent. Investors might also like to look at leveraged loans and CLOs where the floating rate element and wider spreads provide an attractive alternative to the very expensive liquid parts of the bond market, especially in Europe. However, what will define the successful investment strategy over the next 5-10 years is not the ability to squeeze the last bit of juice out of overvalued financial assets, but how you hedge yourself against it all going wrong. It needn’t if politicians took decisive steps to boost productivity, improve real disposable incomes and encourage long-term investment (after all the funding is so cheap) but as we have seen in the UK this week, political bravery and vision is in short supply. We may eventually get a different policy response but it may need a very negative market reaction to any sense that QE has failed.
Eggs-citing – Easter is always a defining period in the football season and this year it is the challenge for the 2nd-4th spots in the EPL that garners all the interest. Chelsea have the league sewn up, save for some calamitous run-in (surely a conspiracy if that happened, eh Jose?), but there are still a number of clubs hoping for spot in next year’s Champion’s League (not that the rest of Europe will be quaking in their boots about the English challenge). My team should hang in the top four and could even finish above City, but Arsenal, Liverpool, Southampton and even Tottenham have all got that Europe prize to play for. United play Liverpool this weekend in what will be a very important step towards that top four spot. I’ll be watching that and hopefully celebrating a Red Devils victory along with success in the London Youth Cup U-15s Cup Final for Bedhead FC. Now if Felix got the winner….