After a volatile few months the outlook for sovereign yields continues to remain somewhat controversial, and the short term trend is perhaps even harder to anticipate given the recent developments on the global macroeconomic scene. 

To start with, the persistent uneasiness around China’s growth and corporate leverage and their sustainability has recently tampered the optimism of European investors and policymakers, which generally bodes well for sovereign bonds.

This is because such an environment prompts some to shift to less risky assets but also because it increases the downside risks for inflation and growth. This explains why the 10 year German yield (the benchmark for Euroarea) dipped to its lowest level since May in the midst of the Chinese-devaluation induced volatility.

However, these gains were to some extent reversed, in part because of an unwind in “safe-haven assets” demand with other factors adding to this movements in my opinion.

To be more specific, I am of the opinion that the wild ride experienced by the EUR sovereign yields in May-June this year has left investors more aware of the importance of technical factors and this prompted them to be faster in realising gains after yields dipped to below 0.6%. Expectations about higher supply in September might have also played a role in their decision taking as during this month the bond issuance net of redemptions and ECB buying is expected to turn again positive (i.e. supply exceeding demand which, as with anything else, has negative implications for prices, all else equal).

Against this backdrop, the German 10 year bonds underperformed US bonds in August although it is widely accepted that Europe remains more vulnerable to the global growth and inflation downturn, as it was in any case challenged by its domestic shortcomings. At the other end, the US economy has proven its relative resilience and could even be in a position to tighten its monetary policy later on this year.

It is thus somewhat surprising that the yield gap between the two regions narrowed even as the European Central Bank downgraded its outlook last week and reckoned that risks are now largely on the downside. What is more, speculation is gradually building that it could soon expand its sovereign bond buying programme (QE) and if such expectations become more widespread, the demand for Euroarea government paper could soon pick up as the “QE2 trade” should start before an eventual extension is effectively announced; this is what happened last year, post Draghi’s Jackson Hole speech delivered in August, which triggered beliefs that ECB could soon embark on QE.

Having said this, there are concerns that China’s efforts of preventing a hasty fall in its currency is a downside risk for sovereign bonds (Eurorarea and US alike). This is because, when intervening in the FX market to support the currency, China would have to sell the foreign currency and buy its own.

However, its FX reserves are generally in the form of sovereign bonds rather than cash which would mean that the local authorities are selling Euro and USD bonds. The latest data, published on Monday, showed that during August, China’s FX reserves fell by almost USD100 billion, double the rate experienced in July, to USD3.56 trillion.

Finally, another market driver this month might be the political risk, with Spanish and Greek elections having the potential of supporting the search for less risky assets, such as government bonds.

 

This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are 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. 

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