Summer's Gone

The ECB has cemented low rates for a long time and it will also resume buying bonds. Can yields rise substantially in that environment? I suspect that bond yields remain low, even if they don’t plumb new depths for a while. More interesting than the rate cut and the re-boot to QE were Draghi’s comments about the need for fiscal stimulus. Is anyone listening? How will we know if governments respond positively? Fiscal stimulus will boost aggregate demand and raise borrowing. It’s the thing that all bond investors will be looking for over the next year and especially in Europe as Mario Draghi steps aside for Christine Lagarde. Unless governments raise their borrowing and sell more bonds, the spread of negative yields will continue.  

Less duration for now

Just like the England cricket team’s batting averages during this summer’s Ashes Test series, my conviction in the long-duration trade in fixed income has faded somewhat. Don’t get me wrong, I don’t see much room for the trend of lower yields that marked the summer of 2019 being significantly reversed anytime soon. However, for the moment the momentum in government bonds has stalled, reflecting the super-strong price rally that we experienced over the summer coming to an end. Indeed, the price return for several bond indices in the three months to the end of August was the strongest since the Lehman crisis era and it was almost inevitable that the market would have to correct at some point. The usual burst of new issuance in September – from corporates and sovereigns – and profit taking ahead of some challenging risk events (Fed, ECB, US-China trade talks, Brexit) has combined to reverse some of the August rally in bonds.  Just to give you a picture, August was the best total return month for the global aggregate bond index since November 2008 with a performance of 2.29%. As of September 12th, this month’s total return for that index was -1.16%.

More help from Mario

The macro picture still supports bond yields remaining low. In my opinion the US economy is still some ways away from a recession, but growth has slowed and particularly in the manufacturing sector. But the growth picture is worse in Europe given that the underlying growth rate is weaker and that parts of the European economy have been badly hit by the slowdown in world trade that has resulted from the US’s aggressive policies on tariffs. In response to this, monetary policy is being eased. The latest round of easing came from the European Central Bank (ECB) this week which announced a package that is unambiguously positive for bonds. To recap, the ECB cut the deposit rate a further 10 basis points (bps) to -0.50%. It also announced that it would resume quantitative easing to the tune of €20bn per month for an unlimited time. ECB President, Mario Draghi, said that rates would remain low and the bank would keep buying bonds for as long as it took to get inflation credibly back to target. In addition, the ECB also introduced a tiering system for banks which means less of the excess reserves they hold at the ECB will be subject to negative rates (thus easing the pressure on banks net interest margins) and that there would be even more generous terms on upcoming long-term repo operations designed to provide plentiful liquidity to the European banking system.   

Credit looks ok

The majority of reactions I have seen from economists suggest that the ECB package won’t be sufficient by itself to boost economic growth and inflation in the Euro Area. However, if the central bank cuts rates and announces it will be buying sovereign and corporate bonds for an unspecified period, then it’s difficult to come to any other conclusion other than that yields will remain lower for longer. The technical trends that have driven bond yields this low will be even more powerful given the supply-demand dynamics and the combined effects of the search for yield and the need for duration. Consider also the liquidity steps and the package is good for credit as well – providing the economy does not fall off a cliff. Banks will see some relief that their excess return holdings are not just draining profitability, and this should reduce the need to charge retail customers for their deposits. Corporate credit will be supported by some ECB buying of bonds but also at the fundamental level by continued low borrowing costs which helps leverage in the credit market. The market weighted coupon on outstanding debt in the European corporate bond market is currently just under 2%. This will fall further in the months and years ahead such that the cost of debt to companies will become even cheaper. European credit indices performed very well in the wake of the ECB announcements, outperforming government bonds by 25bps in investment grade and 50bps in high yield.  

Call to arms

It has been a theme of my blogs recently and of conversations with clients that the effectiveness of monetary policy in a regime of negative rates is increasingly being called into question. Draghi acknowledged this at the press conference following the ECB decision when he called on Euro Area governments to cut taxes and spend. Fiscal policy is needed to boost aggregate demand and to address some of the structural issues that have constrained productivity and have led to excessive savings behaviour. If states can be seen to be providing things that individuals have been saving for in an era of austerity, then maybe consumer spending can pick-up and the supply of excess savings can diminish. Higher budget deficits would surely reduce the flow of excess savings. This should lead to higher bond yields. The problem is how this will be achieved. The idea that governments will come out and explicitly say they are following the ECB’s advice and boosting fiscal stimulus is fanciful, let alone in a co-ordinated way. Investors will have to closely scrutinise government budget plans and borrowing projections to judge whether the fiscal taps are being turned on. It’s hard at this stage to bet that this will happen, and the opportunity cost might be some additional performance from bonds before it becomes clear – if it ever does – that fiscal policy is taking over the burden of trying to boost growth and inflation.

Is the economy that bad?

The consensus GDP growth forecast for the Euro Area this year and next is 1.1%. Consumer price inflation is expected to remain around 1.3%. While some countries may experience negative growth, these aggregate numbers are not screaming recession (2012 and 2013 saw negative GDP growth in both years). One can understand why the Dutch central bank questioned the decision of the ECB to re-start QE when, in its words, the Euro Area economy is growing at full capacity. Over the Atlantic the Federal Reserve (Fed) is widely expected to cut its policy rate again on September 18th.  Yet the latest data from the US suggested that the labour market is as strong as ever – unemployment at 3.7%, wage growth at 3.2%, and core consumer price inflation at 2.4%. Central banks obviously see a need to go back into negative real interest rate territory, but one can understand why many commentators think this is unnecessary. The stock market says, whatever, and is facing new all-time highs.

Inflation?

With underlying yields very low still and credit spreads recently drifting down towards the bottom of their recent ranges, it is not obvious where significant returns are going to be made in bonds in the next few months. The US has the greatest potential for even lower yields but if Jay Powell resists Donald Trump’s advice and sets interest rates according to the growth and inflation outlook, even here investors might be a little disappointed. One area I am watching is the inflation-linked space. Break-even inflation rates moved lower over the summer in line with long-term government bond yields. In the US the 10-year inflation break-even is currently around 1.62%, so it is lower than the prevailing inflation rate. It is also suggesting that inflation stays pretty much the same for the next 10-years, which seems unlikely given that the 10-year historical average is around 0.4% higher. In the Euro Area, 5-year/5-year forward inflation rates (one of the ECB’s preferred indicators) is around 1.3% today. This year’s average has never been lower. It tells us that the market has little confidence in the ECB’s ability to raise inflation but also that buying inflation protection today is a cheap option. If there is going to be a turnaround in the global inflation-rates cycle, it is likely to show up first in break-evens. It’s worth having that exposure in a portfolio right now.

Cautious bond strategy

So to summarise in the wake of the ECB’s decision and the ongoing concerns about the global macro outlook I suspect that yields remain low. However, the price action over the summer is being unwound to some extent and that suggests that we have seen the lows in yield for the time being. A less aggressive exposure to longer duration assets is thus sensible. A real reversal requires the economic data to look better, inflation to pick-up, confidence to be improved by a US-China trade deal, and a resolution to Brexit and some signs that fiscal policy is going to respond to the demands of the ECB. That is a tall order.  

All the ball games 

The summer will be well and truly over once the 5th Ashes Test match is over. It’s been a fascinating summer for cricket fans with the England World Cup win and a riveting series of cricket between England and Steve Smith. I write on day 2 of the current match and things look evenly set, with the weather also playing its part. England will have to wait a while for another attempt to regain the Ashes and concentrate on test match batting ahead of that. Football also returns this weekend after the international break. Leicester have won the premier league more recently than Man United, which would have been an unthinkable thing to say a few years ago. Times have changed, and the Reds are a long way off being the major force in English football that they were up until 2013. However, they need to start getting results and it will be a hard game against Leicester. Time for Harry Maguire to show his old team what they are missing. Meanwhile, let’s hope the men in (slightly off) white can at least tie the Ashes series.

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