Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Guy Monson, Chief Investment Officer and Niloofar Rafiei, Economist, Sarasin & Partners explain the recent changes in the European bond market.
Just as we had gotten used to low and negative yields, bond yields have risen sharply. The sudden selloff in European bond markets from mid-April was widely unexpected, and is yet to be fully explained.
After falling to a trough of 0.07% in mid-April, the yield on 10-year German bunds has climbed sharply, reaching a recent peak of 0.721% in mid-May. The rising trend of negative yielding bonds, an unusual scenario in itself with creditors paying borrowers to lend money, has also been going back into reverse.
Switzerland’s 10-year yield increased from -0.212 back into positive territory in early May. What’s more, the European bond market selloff did not leave US bond markets unperturbed. Contagion crossed the Atlantic over the month, with US borrowing costs rising to their highest level this year (2.293%) on 13th May.
Inflation Optimism, Or Market Realism?
While there is no single explanation for the recent reversal in bond yields, many factors may have contributed. Economic theory posits that long-term interest rates are based on a weighted average of expected short-term interest rates in turn determined by expected real rates and expected inflation, plus a ‘term premium’ to reflect risk aversion. According to this principle, it could well be that recent improved sentiment, better economic data especially in Europe, and higher oil prices versus recent sharp falls may have led to an upward revision to the inflation outlook.
If so, the US, Europe and the UK – all of which are currently on or on the verge of negative consumer price growth – are unlikely to see prolonged price weakness. Indeed, Eurozone consumer price inflation accelerated to 0.3% in May.
However, some argue that this reasoning is simply too optimistic. The US barely grew in Q1 2015, rate hikes are being pushed further into the future, and emerging markets are quickly losing steam. Alternatively, then, it could well be that the recent selloff in bond markets reflects greater realism, with the market correcting its previous extreme positioning. In Europe, fast money was front-running the Eurozone’s quantitative easing program, and the fact that there was speculation circulating that the ECB might have to taper its program after just one month indicates the degree of nervousness in the market.
The perspective on economic fundamentals has not changed, but rather the momentum trade (based on speculation) has changed direction. In this scenario, the current reversal is actually a correction of the previous overshoot.
Greek Default Risks Rising, But Grexit Risks Falling
An alternative hypothesis is that the recent rise in yields reflects worries over euro area disintegration as the Greek debt drama drags on.
In the space of 6 months, the Greek economy has changed course. January’s snap elections installed a new government determined to unwind the austerity conditions of its €172bn bailout package in favour of more pro-growth reforms. In order to unlock Greece’s remaining €7.2bn tranche of bailout funds – withheld since December 2014 – negotiations continue between the troika of the European Union, the International Monetary Fund, and the European Central Bank (ECB) and the new Greek government over sensitive economic reforms, including labour market and pensions.
Meanwhile, the Greek banking system has become increasingly fragile. Deposits in Greek banks have been reduced by 15.7% since November 2014, suggesting ‘flight to safety’. In response, the Greek government has resorted to desperate measures to find alternate sources of funding to repay its debt obligations, as well as public salaries and pensions.
In our view, while the risk of Greece defaulting on its debt has risen substantially over the past several months, the probability of Grexit has been reduced. Crucially, the ECB has stated that it will continue to provide emergency liquidity assistance, even in the case of sovereign default, so long as its banks are solvent and have sufficient collateral. With no imminent prospect of a deal in sight, and both sides remaining fiercely adamant in their positions, the next phase could well be the introduction of capital controls by the Greek government to help counter the risk of a bank run.
With Contagion Risk Afoot, Is Volatility The New Normal?
Of course, the risk of contagion from Greece has contributed (in no small part) to the sharper rise in bond yields in peripheral economies. Spain, Italy and Portugal have all seen their yields increase from recent lows by as much as 75 basis points, 79 basis points, and 97 basis points respectively (compared to 65 basis points for Germany). Bond market volatility has increased.
Emerging markets have not been immune either. The bond market selloff, together with the increase in oil prices – a positive for exporters such as Brazil and Russia, but a negative for oil importing Asia – has caused a reassessment of emerging market risk.
Ultimately, bond yields are expected to rise as the recovery gains pace. However, the recent sharp increases are contrary to the modest rises for which many had hoped. And while the recent selloff may be temporary in nature, even after a new equilibrium is found, volatility may remain a prominent feature of the bond market.
What Next For Global Bond Markets?
Firstly, we expect that markets will remain in a state of flux as the US Federal Reserve begins to normalise its monetary policy, with the first rate hike likely to be this September. Secondly, given that the euro area is in the early stages of its large monetary stimulus programme, and Japan potentially intensifying its own approach, we see greater divergences in yields reflecting the opposing paths of monetary policy.
In the meantime, however, the continuation of very low policy rates is set to encourage ongoing heightened sensitivity and volatility in bond yields across the globe. This suggests that government bond markets may gradually see their ‘safe haven’ status eroded as volatility rises, yields drift upwards and peripheral bond and credit markets are subjected to periodic bouts of risk aversion.
Against this backdrop, cash or very short dated bonds again have a role in our asset allocation models - yes the nominal rate of interest generated is at or close to zero, but with much of the world facing flat or negative inflation the real rate is marginally positive. More importantly if bond yields do spike once again, then cash at least is a genuine refuge.
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