Are the markets becoming too optimistic?

I’ve repeatedly argued that the spike in Euroarea government yields (drop in prices) experienced since end March 2015 is due to be reversed as growth and inflation outlook are not yet supportive for such moves and the central bank’s bond buying program coupled with the low budget deficits (i.e. low bond issuance) form a supportive technical backdrop. However since then the prices rebounded for a few days only to plunge on Tuesday and Wednesday yet again. The first trigger appears to have been a mild positive surprise in euro area inflation which came out at 0.3% against forecasts for 0.2%. A day later, ECB’s President Draghi speech was followed but a fresh sell-off with the German 10-year Bund losing as much as 2.1% .

Some commentaries attributed this to Draghi’s optimistic tone but I think that the general stance was rather cautious. Here are some key takeaways:

1. Inflation forecast for 2015 were revised upwards but those for 2016-2017 were left unchanged as were the growth estimates for 2015-2017. Bond yields, especially the longer dated ones, should be sensitive to medium and long term expectations rather than one-year projections.

2. The ECB’s chief reckoned that risks surrounding the economic outlook for the euro area remain on the downside.

3. “The dynamics of loans to non-financial corporations remain subdued. They continue to reflect the lagged relationship with the business cycle, credit risk, credit supply factors, and the ongoing adjustment of financial and non-financial sector balance sheets.” In my opinion credit growth is mandatory for all this money printing to reach the real economy.

4. While in the previous statement Draghi said that he expects economic recovery to “broaden and strengthen”, he now dropped the reference to stronger growth. Referring to this he said “you quite rightly pointed out there is a difference. Let me say, the recovery is on track, exactly according to our projections. However, we had expected stronger figures, stronger than our projections originally, and at some point, some indicators were showing this. There has been some loss of momentum, modest I would say, mostly due to a weakening of the economies outside the euro area, emerging markets mostly. On the other hand, all survey indicators and other data show that domestic demand in the euro area remains strong, so we just wanted to point out this slight loss of momentum coming from global trade”.

This stands to argue that the ECB has in no case become more optimistic and that it acknowledges the impact of the global macro conditions. As such, investors should probably be worried by at least two factors: (i) the Chinese economic data has surprised on the downside with the Citi Economic Surprise Index now deeply into the negative territory (ii) global growth forecasts have been downgraded with the latest notable cut coming from OPEC on Wednesday.

5. When asked about his thoughts on the recent rise in Bund yields, here is what Draghi had to say: “There have been many explanations that have been given, one of which you hinted at, namely that there is an improvement, in the perspectives of growth. A second explanation is higher inflation expectations.

A third explanation is actually a bunch of technical conditions present in the markets like, and here I’m going through them quickly, first, there have been one-directional investments into long-term maturities, and the turnaround has been quite abrupt. Second, there was strong supply pressure, in the sense that issuance had been quite significant, by various governments in the meantime. Third is that when shorter-dated German Bunds became eligible, previously they had not been, because of their negative yields, there was less need to buy longer-dated bonds, and that produced a steepening of the curve. The fourth technical condition is simply that volatility by itself generated further volatility and further selling, and a fifth is poor market liquidity because of the absence of certain significant investors during this period of time.

Now, it’s very difficult to distinguish between these three sets of factors, sets of conditions, so we won’t speculate exactly on what explanation is the most likely. But certainly one lesson is that we should get used to periods of higher volatility.

The way I interpret this is that Draghi is not convinced that growth and inflation expectations are underpinning the recent re-pricing in government yields; he spent more time discussing the possible technical factors and refrained from pinpointing to what is the more likely explanation.

6. ECB’s head said that the structural unemployment is “on the border of 9%. Monetary policy cannot address the structural component of the weakness in the economy. It cannot address the reasons why potential growth is low. These issues should be addressed by structural policies.” To put it differently, to get unemployment below 9% the euro area will have to implement reforms rather than rely on ECB; however, in Draghi’s own words, the recovery is dampened by “the sluggish pace of implementation of structural reforms”. The next question thus would be whether growth and inflation can pick up significantly.

To conclude, I do not side with those who see scope for an upward revision in inflation expectations and looking at the 5 year-5 year inflation swap I have to say that there are many of the same view as this proxy of the inflation expected over 2020-2025 is below 1.8% and hardly moved since end-14. Furthermore, while some data prints might have been positive, the momentum has significantly weakened with the Economic Surprise Index for euro area now close to zero after a strong Q1. Assuming my views are correct, government bonds should rally from here although further volatility cannot be ruled out as Draghi himself pointed out.

Raluca Filip is 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.