While market participants were kept busy during the summer months with the widely unexpected Brexit outcome, we have seen the focus, since then, shift towards the US elections. The outcome of this has caused a significant reassessment of bond yields.
These moves were driven by shifts in markets’ expectations, mainly regarding US economic growth prospects, the pace of rate hikes by the US Federal Reserve, the possibility of similar fiscal and monetary responses in other economic regions as well as the impact of the apparent rise of popularism on upcoming elections in Europe.
These implications play a decisive role in the direction of financial markets in general and more pertinently in the level of benchmark bond yields.
The Maltese government bond market is no exception.
It is therefore critical for local participants to understand the reaction function of the Malta government bond (‘MGS’) yield curve to international forces in order to identify how local sovereign bonds are impacted as global economic events and market developments unfold. In doing so we analyse both the level of MGS yields as well as the difference between MGS yields and benchmark yields, also known as the credit spread.
The market convention for European benchmark bond yields are German government bonds.
For the purpose of this illustration one can look at the variation of the yields of the three per cent 2040 and the 4.5 per cent 2028 government bond issues in response to recent events.
The yields of these issues since the end of 2015 is comparable with the average yields of comparable euro area government bonds with similar credit rating and maturity. It is important to recall that as yields move lower, bond prices move higher and vice versa.
While MGS yields do, in general, move in tandem with euro area comparables, an evident divergence occurred the beginning of July following the Brexit outcome. The safe haven flows triggered by the risk-off sentiment following the outcome of the UK vote drove benchmark bond yields to all-time lows. Additionally, credit spreads of euro area sovereign bonds tightened rapidly following the event.
As yields move lower, bond prices move higher and vice versa
Conversely, MGS yields did not tighten immediately in the same manner as those of comparable sovereign bonds. Nevertheless, the credit spread has tightened in a more gradual fashion and converged back to the level of comparable sovereign bonds over the following three months.
As we moved to October, benchmark yields started inching higher. Credit spreads of comparables were held fairly constant up until the date of the US elections.
The unanticipated outcome of the elections triggered a reassessment of the speed at which interest rates will rise in the US, with potential knock-on effects for Europe. This led to an immediate rapid move higher in benchmark yields, but also a general widening in credit spreads.
This time we have seen an aggressive reaction in Malta government bond yields commensurate with the general sell-off in benchmark yields and the spread widening, as seen in comparables.
What is also worth noting is that, in the days leading up to the elections, we had started to observe yields move higher by circa 20 basis points (or 0.20 per cent) since the low on October 24 to November 8 – in line with the direction of comparable bond yields.
Conversely, the long-end seems to have maintained its richness as long-end yields remained practically unchanged during this period, whereas benchmark yields moved higher – implying a tighter credit spread. This notable development may be partially explained by the greater retail participation and trade flows around the recent issuance at the long-end.
Following the outcome of the US elections we have seen a quasi-parallel shift upwards, with the 2028 and the 2040 yields moving higher by 35 and 38 basis points respectively.
Nevertheless, the long-end of yields has maintained the divergence in the credit spread versus comparables. As a result, on balance, the long-end seems to be relatively expensive in absolute yield terms versus comparables.
While the market reaction has been significant, it is challenging to attempt to ascertain directionality in light of the contrasting forces driving the market. We are, however, likely to see an acute correction to the recent sell-off as the post-elections euphoria starts to wane and uncertainty around the actual execution starts to emerge.
The low economic demand and deflationary pressures are still very much a threat to the European recovery with the political fragmentation posing further drag on any concerted initiatives repeatedly hinted at by monetary authorities.
This commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell, or an offer or solicitation to buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Matthias Busuttil is an investment advisor at Curmi & Partners Ltd.