The summer bond market rally

The historic consultative Brexit referendum on June 23 had wide implications across various asset classes, namely equities, currencies and also bonds.

The immediate reaction across international financial markets as the surprising result was announced in the early hours of June 24 was well documented across the local and international media.

Global equity markets experienced a sizeable sell-off with the UK’s FTSE 100 dropping an extraordinary 8.7 per cent as the market opened on and Germany’s DAX losing 10 per cent of its value. Equity markets partially recovered throughout the day with the FTSE 100 closing 3.2 per cent lower at 6,138.69 points, Germany’s DAX 30 finishing down 6.8 per cent and France’s CAC 40 ending eight per cent lower.

The worst hit across the EU was Greece (which plunged more than 13.4 per cent) followed by Italy and Spain with declines of 12.4 per cent each – the biggest ever one-day declines for these markets.

Sterling plunged in value against most major currencies, dropping by 10 per cent to its weakest level against the US dollar since 1985. Sterling also declined by eight per cent versus the euro in the immediate aftermath of the result and by 15 per cent versus the Japanese Yen. The British pound had not experienced such a decline in a single day since Britain’s exit from the exchange rate mechanism in 1992.

The recovery in equity markets since Theresa May took office on July 13 has been remarkable. In the past few weeks, the FTSE 100 rallied up to 6,900 points (+12 per cent) with Germany’s DAX surpassing 10,700 points representing an increase of 16 per cent from its low of 9,268 points on June 24.

In the US, all three major equities indices have been reaching fresh record levels almost on a daily basis.

However, the remarkable developments across sovereign bond markets have probably remained unnoticed especially by many local investors. As I explained over recent years, there is an inverse relationship between yields and bond prices. An increase in the price of a bond represents a decline in yields and vice versa. The recent downturn in yields is therefore positive news for those investors who are already exposed to the sovereign bond market.

Since the Brexit result on June 24, yields immediately dropped heavily as the market anticipated a new package of monetary stimulus by the Bank of England to combat the weakening British economy as a result of the uncertainty arising from the decision to exit the EU.

Short-dated UK government bonds (referred to as Gilts) maturing in 2019 and 2020 briefly traded below zero last week while the 10-year government bond yield sank to 0.51 per cent last week from 1.5 per cent in early June, representing a significant rally in prices of UK Gilts. The 30-year UK Gilt dropped to an all-time low of 1.23 per cent compared to a yield of 2.19 per cent in June shortly before the referendum. This sharp decline in yields represents an extraordinary upturn in prices.

In fact, certain international financial commentators are making observations about the return of over 30 per cent generated by the longest-dated UK government bonds this year which makes this one of the best asset classes so far in 2016.

Yields continued to decline following the monthly monetary policy meeting of the Bank of England on August 4 as the BOE announced a drop in interest rates for the first time since March 2009 and revived the quantitative easing programme with a £70 billion bond-buying programme.

Prices of several MGS rallied in recent weeks with the majority of the medium and long-dated bonds trading up to new record levels

The extensive monetary stimulus package which exceeded market expectations created further downward pressure not only on bond yields in the UK but also across the globe.

Additionally, the governor of the BOE Mark Carney also commented that interest rates are expected to be cut further towards zero in the months ahead and possibly introduce more QE. However, he almost ruled out the prospect of negative interest rates.

The BOE’s stimulus plan and the remarks of additional easing continued to intensify the drop in global bond yields in recent weeks. Three of the world’s major central banks are now engaged in quantitative easing: the Bank of Japan, the European Central Bank and the Bank of England.

Across the EU, the 10-year benchmark German Bund dropped to an all-time low of -0.204 per cent on July 6, 2016 and has remained particularly volatile since then.

After recovering partially in recent weeks, it dropped back to a low of -0.121 per cent last week. Meanwhile, across the periphery countries, the 10-year yields of both Italy and Spain hit fresh all-time lows last week.

The Italian 10-year bond touched 1.051 per cent compared to 1.368 per cent before the Brexit referendum. Likewise, the Spanish 10-year yield dropped to a record low of 0.914 per cent compared to 1.540 per cent in early June and 1.781 per cent at the start of 2016.

As I have explained in the past, the Malta Government Stock market mirrors developments across the eurozone and in particular the peripheral countries with credit ratings similar to Malta’s. Prices of several MGS rallied in recent weeks with the majority of the medium and long-dated bonds trading up to new record levels.

This marks an almost complete reversal of the sharp downturn in MGS prices between mid-April and end of May 2015 when, in the space of a few weeks after the start of the QE programme by the ECB in February 2015, MGS prices first rallied strongly and then started to decline in dramatic manner.

As an example, the longest-dated MGS at the time (the three per cent MGS 2040) which had been offered on the primary market at par (100 per cent) in February 2015, first jumped by 19 per cent to over 119 per cent in April 2015 and then dropped by more than eight percentage points in a few weeks to 111 per cent.

Most of the medium and long-term MGS prices have traded up to new record levels earlier this week with the exception of the 4.8 per cent MGS 2028, the 5.1 per cent MGS 2029 and the three per cent MGS 2040.

These have still performed very strongly in recent weeks but failed to reach last year’s record levels. For example, the three per cent MGS 2040 has now surpassed the 115 per cent level once again for the first time since April 2015. The CBM bid price for this long-dated MGS had reached a low of 103.34 per cent on July 2, 2015.

On the other hand, the 4.3 per cent MGS 2033, for example, which had reached an all-time high of 136.53 per cent in April 2015 is now above 138 per cent after recovering from a 2016 low of 129.32 per cent on January 13. Likewise, the 5.2 per cent MGS 2031 recently exceeded the previous high of 149.25 per cent also reached in April 2015 after dropping to a 2016 low of 141.10 per cent also on January 13.

The volatility in the global bond markets (and also the MGS market) over the past 15 months is truly unprecedented and created a significant wealth effect which probably remains unnoticed in some cases as certain investors may have not noticed the strong double-digit gains in most Malta Government Stocks.

On the other hand, it should serve as an eye-opener to those more active investors who are well aware of these exceptional gains and who very often believe that these are normal circumstances.

Bonds do not generally produce such stellar returns and this is due to the exceptional political and economic circumstances in recent years which have led to very low or negative interest rates and other expansionary monetary policy measures.

Although the imminent listing of the new 25-year MGS on offer earlier this month should prove to be another immediately profitable investment – as the price is expected to start trading at well above the offer price of 101.75 per cent when trading commences shortly – investors heavily exposed to the long-term MGS market should act with caution and get prepared for the inevitable in the future.

At some point in time in the years ahead, when economic conditions across the eurozone and other parts of the world gradually improve and inflation starts to increase, the extended monetary stimulus measures will start being reduced by the various central banks. When markets begin to anticipate this eventuality, the extraordinary gains in the various MGS should start to unwind, similar to the trend seen in April and May 2015.

Those investors hoping that these circumstances can last forever should take note of such an eventuality to ensure that they are not caught off-guard once market conditions change.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

Edward Rizzo is a director at Rizzo, Farrugia & Co (Stockbrokers) Limited.

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