By Jon Jonsson
Last month wrote that technical forces were the real drivers behind negative yields in European government bond markets, and that anyone buying these bonds was taking a big risk. The initial tick-up in yields at that time turned out to be the starting gun for a truly remarkable sell-off that saw the German 10-year Bund yield leap from 0.07% to 0.70% in just 17 trading sessions.
Complacency coming into sell-off
Complacency had built up in fixed income markets, thanks to an extended period of low yields. With the retrenchment, at least some of that appears to have evaporated. Core government bond indices in Europe have shed 3%-4% from their peak valuations, wiping out much of this year’s accumulated return. At this point, a further 25 basis points of upward movement would eliminate 12 months’ worth of coupon income for all developed government bond markets; for Germany, that breakeven point is only five basis points away.
In our view, investors really need to question whether fixed income can play its traditional role as a provider of stable income with low risk to principal when priced at these levels. They also should ask whether this was just a bounce in the longer-term trend of ultra-low yields–or the start of something bigger.
Little change in growth and inflation expectations
After all, fundamental expectations don’t appear to have changed much. The stabilisation of oil prices explains some of this sell-off, we believe, but indicators such as the five-year, five-year forward-starting inflation break-even rate, for example, have barely moved: It remains just above 2% in the U.S. and well below 2% in Europe.
Indeed, the near end of nominal and inflation-linked curves has not seen much of the action over recent weeks. Fed rate expectations for 2017 have moved up by less than 25 basis points; the market has not been pricing a more aggressive Fed for the near term. In fact, we have seen the biggest re-pricing in very long-term rate expectations on the German curve, where the 10-year, 10-year forward rate, which had tumbled to as low as 1%, bounced back to around 1.75%. We saw a similarly big move of 50 basis points in the same forward rate on the U.S. curve.
A technical floor for yields?
This is important. We have argued that rates at these levels are not supported by fundamentals. Even an ultra-conservative view on Germany’s ability to generate 1% growth and 1% inflation over the long term should make one uncomfortable owning them. And yet, we have not seen re-pricing toward fundamental valuations at the shorter end of the curves, and there are purely technical reasons for the steepening between 10 and 20 years: The European Central Bank’s quantitative easing purchases have been at shorter maturities over recent weeks, for example; and with 10-year, 10-year forward on the German yield curve at 1%, it was very cheap for investors to go short. In our view, this removed some of the uncertainty about the timing of the bond market sell-off that might have discouraged traders from taking a position. In other words, my blog four weeks ago may have coincided with a technical floor for yields that backs up the argument from economic fundamentals. Bond markets may have finally decided that enough is enough.
Of course, this thesis can still be tested. Volatility and gap risks to both the downside and upside are elevated with yields so low and markets so illiquid: Don’t forget the “flash crash” in US Treasury yields in October 2014. It’s difficult to tell whether pension funds and insurance companies will start selling duration as their liability discount rates start to rise–or start buying it because they remain so under-hedged. And, if Greece defaults, no one is going to want to sell their Bunds.
Waiting for reality in pricing
On balance, however, we still don’t believe these markets reflect fundamental economic reality and now we have some evidence that the technical downward pressure on yields may be weakening. The rest of 2015 could be characterised by a battle between technicals and fundamentals, but against this background, we anticipate a continuing sell-off, with any moves back towards the levels we saw four weeks ago likely proving temporary.
Jon Jonsson is a senior portfolio manager, global investment grade fixed income, at Neuberger Berman
Comments