In recent weeks, the bond and equity markets have been in turmoil. The epicentre of the problem is clearly on the side of the bond market, where the spectre of a crash is haunting investors – especially since the Fed is beginning to worry openly about excessively low interest rates and the overvalued stock market. On the equity market, the rise in interest rates was investors’ chance to take their profits, especially since, on the political plane, the risks of a Grexit and, more recently, a Brexit have come to the forefront. .….
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Eric Brard, Global Head of Fixed Income bei Amundi
A joint note from the Research and Fixed Income departments
Should we fear a bond crash, Grexit or Brexit? In a nutshell, our answer is No. Having said that, investors should be prepared for increasing volatility.
Towards a Bond Crash?
False alarm or serious warning?
No doubt it is statements from US fund managers on the abnormally low interest rates and the bond bubble that are behind the recent correction, seen in most of the advanced countries. But what is getting the most attention is that it happened on the German bond market, because the Bund 10-year rate had fallen to 0.05%, and some were even expecting it to fall into negative territory, as we are already seeing in Switzerland. In just a few days, it came back to nearly 0.8% (in trading on 7 May) before stabilising around 0.5%, while short-term rates stayed in negative territory.
Interest rates are still too low with regard to all the existing valuation metrics. However, unlike the equity markets, the bond markets cannot suffer a crash when the central banks are at work. The example of Japan shows the extent to which securities-buying programmes are an overly decisive factor for interest rates. In the eurozone, the ECB’s purchases will keep bond yields very low. The ECB bought only €110 billion in securities (out of a programme of €1100 billion). In other words, 90% of its securities purchasing programme still lies ahead. All other things being equal, the imbalance between issuance schedules and demand for ECB securities clearly argues in favour of another downturn in German bond yields in the months to come.
The ECB has committed to continuing its QE until September 2016, even if the economy improves sharply. Indeed, it will take time to contain deflationary pressures. The recent rise in long-term rates illustrates the need for anchoring expectations with a long-lasting securities-purchasing programme. Because a failed QE (i.e. a sharp rise in interest rates or the euro) would quash the recovery and fears over the solvency of some States would surely resurface.
The curve steepens again in a gradual reflation phase
That said, regardless of any technical factors that many have caused the recent correction, it is important to note that the correction on the Bund is coming soon after an upward correction of inflation expectations. The five-year inflation swap in five years – a metric touted by Mario Draghi to measure market anticipations – has risen sharply over recent weeks. It is striking to note that for the past 18 months, this metric has been closely correlated to oil prices. So everything seems to be happening as though medium-term inflation expectations depended on today’s oil prices…
It is clear that if the price of oil stabilises at current levels (between 60 and USD 65), projected (year-end) inflation will be revised upward in the eurozone. But that is clearly unrelated to the medium-term inflation outlook. No more than the decline in oil prices is a vector of deflation, the rise is not a vector of self-sustaining inflation. The ECB will probably have to give more instruction on the fact that it is the trend in core inflation that counts above all. Yet on that side, we expect no notable acceleration by 2016. It will take more than the cyclical recovery that is expected to drive eurozone unemployment down in any lasting way. The second-round effects on wages cannot materialise in a high-unemployment environment. Not to mention that the recent rise in rates, the euro, and oil threatens to weigh down the economy in the nearer term…
What it means for the markets: long-term bond yields in Germany are not poised to come back up for good. Yet this does not mean they are going to fall back down to zero either. Indeed, low but positive rates would more closely match a period of gradual reflation.
Greece: Exiting the Economic and Monetary Union (Grexit)
Greece’s exit from the eurozone (Grexit) is highly unlikely, because the stakeholders are dead set against it. European authorities do not want to open the Pandora’s Box of an exit from the euro.
Relations between Greece and its creditors are certainly quite tense. But negotiations are ongoing. The risk of a technical default, the setup of capital controls, or more elections (even a referendum on Grexit) is considerably heightened. Public debt is unsustainable in the long term, and restructuring appears inevitable. However, we still believe that the risk of an exit from the EMU or of a disorderly default is low: the surveys show that the Greek people are still quite attached to the euro, to the point that they will make some concessions. Stakeholders have an interest in continuing their negotiations. This year, the Greek economy may fall back into a recession, with the shock of confidence tied to political uncertainty. And the primary budget balance will probably fall into a deficit this year. The agreement, if there is one, will most likely be reached at the very last moment (end-June). Tensions may increase in the final negotiation phase.
What it means for the markets: even though the ECB’s purchasing should prevent contagion to the other bond markets, there may be unpredictable setbacks on peripheral sovereign spreads. Especially given the level of interest rates that have sunk very low (Spanish and Italian 10-year bond yields are lower than the 10-year Treasury yield). In other words, the return of systemic risk related to the Greek situation is unlikely. On the other hand, we must prepare for a resurgence of volatility.
United Kingdom: towards an exit from the European Union (Brexit)?
The Conservative victory on May 7 caught all observers off guard who were not anticipating an absolute majority for either of the two major parties. In the wake of results, Prime Minister David Cameron, voted in for another term, confirmed his intention to organise an In/Out referendum on the European Union “by end-2017.” With regard to the legibility and credibility of economic policy, the removal of the fragile coalition is good news, because in that sense it is a vector for uncertainty that is disappearing. Furthermore, this explains the markets’ very favourable reaction (a rising currency, rebounding equity market). Still, the referendum opens the door to uncertainty of another kind (whether or not to stay in the EU). In the polls – which we now know to be unreliable – there is no clear majority on the Brexit. Yet the economic consequences may materialise well before the referendum. They are mostly about confidence (British businesses, foreign investors), and are thus hard to assess. It is the market variables that will crystallise investors’ fears first.
What will this mean for the markets?
Bond markets: the fiscal adjustment will continue, which is good news for government bond holders. The decline in the public deficit has already been spectacular (falling by more than half since its peak). The deficit, estimated at -4.1% of GDP by the European Commission over fiscal year 2015-16, is projected at -2.7% of GDP over 2016-2017 (the structural deficit would be scarcely higher, and it too would be down sharply). That said, if growth continues to soar, the labour market will tighten further, and inflationary pressures will end up intensifying (somewhat similar to in the US, due to wage pressures caused against a backdrop of weak productivity gains). The theme of a return to inflation could come back to centre stage even faster if the pound should depreciate…
FX market: the new uncertainty could impact the pound in the medium run. Indeed, the current account deficit is 5% of GDP, and the income balance is ever worsening. The UK’s net foreign position, even if it remains low in absolute terms, has deteriorated quickly in recent years (from almost zero in 2011 to -25% of GDP in 2014). In Q4 2014, the current deficit (-5.5% of GDP) was funded to 2.6% of GDP by net FDI inflows. In terms of FDI stock, the UK came in second worldwide, after the US. The bulk of investments are from the other European Union countries. These investment flows are very directly tied to the UK’s membership in the EU. Nearly half of British goods exports and more than one-third of service exports are to the EU. That FDI has just weakened, and the pound could depreciate…
There is no reason to be concerned about Brexit in the short term
In the months to come, Prime Minister Cameron will seek concessions from Brussels, especially in terms of controlling immigration or safeguarding the City’s interests. As things stand, it is unlikely he will achieve his ends. The consensus that now prevails in Brussels is that the UK has more to lose by leaving the EU than the EU has by letting the UK go. Most economic analyses corroborate the one done in Brussels. So “negotiations” promise to be difficult for Mr Cameron. But he has time before him to find a modus vivendi.
Ultimately, we believe that Conservatives should actively campaign to stay in the EU. It is thus clearly too soon to worry about the potential negative consequences of Brexit.
To summarize, what we experienced last week was triggered by a combination of factors:
· Some repricing of the fundamental background linked to the rise in oil prices and the decline of deflation risk – or the increased reflation expectations.
· The accumulation of event risks in Europe, and a high level of uncertainty (Greece, UK elections Eurogroup meeting…).
· The historically low level of interest rates and the growing sentiment that the high valuation of euro denominated assets was opening the door for a correction, particularly among the US investors.
· The very low level of protection allowed by close to zero interest rates in the core markets
The market move has been mainly driven by future market interventions, while real money players were more cautious and do not seem to have changed their positions significantly at this stage. Peripheral as well as credit spreads have remained remarkably solid in this context.
Investment Views
Our call for the coming weeks can be summarized as follows:
· Interest rate downward forces to be still at work: even though the market remains exposed to another brutal interest rate derivatives short selling, the ECB sovereign QE and the need for collateral are still putting downward pressure on rates.
· Increased risk premium: the strong increase in volatility will raise the overall euro market risk premium. Some investors may consider it as an opportunity to reinvest, others with a stronger risk aversion, will target higher interest rate levels. From that perspective, volatility is set to remain high in the coming weeks. In addition, the year to date total return being hit by last week’s downturn, investors will be more cautious in the coming weeks, the risk being of getting into negative performance figures following any additional spike in rates.
· All in all, the combination of these market considerations and the macroeconomic picture should play in favor of a stabilization at a slightly higher level in rates, with a wider range of price action and some persistent volatility. In other words, not a prolonged bond crash, even though the market sent us a clear warning signal last week regarding the consequences of excessive valuation levels.
Quelle: BONDWorld.ch
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