Over the past two weeks the European sovereign yields have been rapidly increasing (prices have been falling) and with them they brought down the prices of most of the Investment Grade corporate bonds. The fall in German Bonds (aka Bunds) seems to have been at the centre of this trend change, with other Euroarea countries, such as France, Austria, or even Malta following suit.
So why did the Bund yields spike from as low as 0.13 per cent to over 0.6 per cent, undoing most of the price gains experienced in the aftermath of the QE announcement? Several reasons were floated, most of which in my opinion can be easily dismissed. I will go through them one by one.
Greece related fears
Some commentaries stated that Italian, Spanish and Portuguese bonds fell due to contagion effects from Greece. However, this does not seem to be the case as these countries have been moving relatively in line with Germany bonds, with spreads showing rather mild changes.
I would go one step further and say that if Greece was at the root of this sell-off than Bund prices should come up rather than plunge, as in this scenario Germany emerges as a safe-heaven. Similarly, we should have seen the US government paper better bid. Such moves would be further supported by expectations for an appreciating US$ (or, in extremis, German mark) as FX gains have the potential to add to the total return should Greek fears become reality.
Oil prices have spiked up, alleviating deflation fears
The bond yields should compensate investors for the credit risks of the issuer and for the inflation expected over the life of the bond. As such, forecasts for higher inflation have the potential of pushing the yields higher. Hence, one could argue that the rebound in oil could have void fears of a secular bear market and in so doing increased long term inflation forecasts.
First, if this is indeed the case I would say that European equities should have found additional support as in this case the deflation risks decrease, which is positive for the growth outlook.
Secondly, long term market measures for inflation have remained at depressed levels and have improved by just 0.2 percentage points since end-March, from 1.6 per cent to two per cent, below the two per cent level deemed consistent with a healthy economy. For the latter I used the five year-five year inflation swap which is basically a measure of the inflation expected over 2020-2025. As technical as this index sounds, I stress that ECB’s president Mario Draghi repeatedly made reference to it in his presentations.
Finally, if higher oil prices somehow led investors to re-asses their inflation forecasts, then other sovereigns, such as the US should have moved in sync. This was not the case with the 10 year US treasury widening by 0.3 percentage points since end-March, while the German yields shot up by 0.5 percentage points during the same time period. The divergence is even more significant if one accounts for the fact that the ECB has engaged to buy government bonds this year.
Stronger data alleviating inflation fears
Somehow related to the point discussed before, some argue that the selloff in Government yields was triggered by better than expected European inflation data (published on March 31) and generally supportive macro statistics.
While the preliminary data showed that Euroarea prices fell by less than expected in March, the improvement in inflation figures in early 2015 is likely attributable to a large extent to the weaker Euro; the depreciation of the Euro means that imported goods or commodities which are traditionally negotiated in US$ are more expensive in € terms.
RBS for example pointed out that food prices had a sizable contribution to the March inflation rebound and that this was due to the € fall as most of the food prices have been declining on the international markets (eg wheat, corn or soybean).
I would say that at this stage a significant depreciation of the € is less likely as markets come to realize that Fed’s interest rate hike is not as imminent as it was feared, removing one of the catalysts for the US$’s strength.
I am also of the opinion that one month does not mark a new trend and that long term inflation views are more significant for markets. As I pointed out already, no large shift appears to be taking place here.
As regards other statistics, indeed many figures have come ahead of expectations although this has been the case for several months now. In actual fact, the Citigroup Euroarea Economic Surprise Index while still positive has been on a downtrend over the last few weeks.
Chinese stimulus
Although China announced a range of growth-supporting measures, these have to been seen in conjunction with the authorities’ commitments of redefining the growth model and limiting further leveraging. To put it differently, Chinese politicians are more focused now on the quality of growth than on the level of growth. Hence, a quick return to seven per cent + growth rates is unlikely in my view and the risks to the downside have increased.
To conclude, the recent spike in Euroarea yields is hard to reconcile with other market data and it is in my opinion unsustainable. The only reasonable explanation I see is profit-taking after a strong start of the year which caused confusion and re-enforced the downside pressure. What is more, the sharp movements have pushed many of the yields back to 2014 levels which, if continued, would mean that ECB’s bond-buying programme was futile. I thus think that the recent correction provides for a buying opportunity.
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.