Global Fixed Income
Weekly discussion of fixed income market action and what it may mean for investors.
Peter Wilson, Global Fixed Income Strategist
Hidden Messages from the Eurozone Yield Curve
- For more than six months, 10-year bond yields across the Eurozone have been rising on modest but steady growth, and from rising headline inflation.
- Yet other parts of the yield curve tell different stories. Two-year Greek bond yields have surged above 10 percent, while the two-year German bond yield is at an all-time low of -0.85 percent.
What it may mean for investors
- We believe that deeply negative short-maturity yields in the Eurozone’s core market will remain a source of downward pressure on the euro for some time to come.
Bond-market observers have noted the gradual rise in 10-year Eurozone yields for more than six months now. Since the middle of 2016, 10-year German bund yields have risen from around -0.2 percent to a recent peak of 0.5 percent at the end of January. Peripheral sovereign markets, such as Italy’s bond market, have seen 10-year yields rise by much more, from near one percent to almost 2.4 percent over the same period. This has widened the differential to German bund yields.
The reasons for this move have become familiar. As a whole, Eurozone growth has been modest but sustained, at a quarterly rate of 0.4-0.5 percent, implying an annual growth rate of 1.6-1.8 percent. Further, business surveys such as the monthly Purchasing Managers’ Indices indicate that this steady growth is set to continue. The fear of deflation that haunted the Eurozone at the end of 2015 and early last year has gone. While core inflation rates are steady, at around 0.9 percent year-over-year, headline consumer price inflation (CPI) growth has rebounded strongly from around zero in early 2016 to 1.8 percent in January 2017. Pressure is mounting for the European Central Bank (ECB) to curtail its bond-buying program, and in December, the central bank announced a reduction in the pace of bond purchases from €80 billion ($85 billion) per month to €60 billion ($64 billion), effective from April 2017, and planned to run until the end of this year. In this context, it is logical that yields should be moving higher; and given the busy election schedule for many European countries in 2017, and the rise of populist anti-euro contenders, it is not surprising that spreads between peripheral sovereign and core German bund yields also are widening.
So far—so simple. However the 10-year sovereign bond yield does not tell the whole story. If we broaden our focus a little to include shorter-term sovereign rates—in this case, the two-year government-bond yield—we often can find new information and fresh insights that can lead to better investment decisions.
For example, this week, two-year bond yields in two very different Eurozone sovereign markets have traded at opposite extremes, giving useful information about investor sentiment and some clues as to the outlook for bonds and currencies in the Eurozone.
Case Study 1: Greece’s Yield Curve Inverts as Default Fears Mount
First, two-year Greek sovereign-bond yields have hit the headlines as they traded above 10 percent, rising by approximately 180 basis points (1.8 percent) since late last month. Ten-year Greek bond yields also have risen, but by much less, from around 7.0 percent to 7.8 percent over the same period—with the result that the Greek yield curve from 2 to 10 years is heavily “inverse.” Of course, finance textbooks tell us that the usual explanation for an inverse sovereign-yield curve (i.e. shorter-maturity bonds yielding more than longer-term bonds) is that short-term policy rates are rising, and that the market expects a further rise in central-bank rates to have beneficial effects on containing inflation—with the result that lower expected inflation and the smaller required risk premium both act to reduce longer-term yields.
This classical model of an inverse yield curve describes a relatively healthy situation of a credible and preemptive central bank. Clearly this is not the explanation of the inverse Greek curve. Credit-market participants know that a yield curve can invert when the market starts to fear a default by a borrower—in this case, Greece. Greece has a €6.2 billion ($6.5 billion) bond that matures in July, and—as three-way negotiations between the International Monetary Fund, the EU, and the Greek government over the release of bailout funds drag on—the market is starting to worry that this bond may not be repaid.
In the run-up to a potential default, the usual yield-based bond-trading considerations are jettisoned and bonds start to trade purely on price. That is to say, investors start to consider just how many “cents on the dollar” they may receive if the feared event actually takes place. Such a default, if it happened, would result in similar principal losses—say, 20, 30, 40 or 50 “cents on the dollar” (percent of par value)—across the yield curve, in longer as well as shorter maturities. However, as the market seeks to price in such a “haircut,” the yield curve can invert as short-maturity bonds see far larger yield rises than longer-maturity bonds (since short-term bond yields typically are more sensitive to market-price movements than longer-maturity yields). This is why financial commentaries often flag yield-curve inversion as a sign of default fears rising in a given market.
Now, in the case of Greece, the base-case scenario remains that realpolitik considerations will mean that a last-minute deal likely secures the release of funds and a worst-case default is avoided (as has happened so often before). However, the “two-year yield as a default warning” is a good example of how an exclusive focus on 10-year yields can miss the key story.
Case Study 2: Two-Year German Yields at All-Time Lows
While two-year Greek yields have been soaring, another part of the Eurozone bond-yield complex has been seeing new lows. While 10-year yields in all Eurozone markets have been rising, and spreads have been widening, since mid-2016, as we noted, the yield on the two-year German sovereign bond (known as the “Schatz”) actually has been making new all-time lows. This week, this benchmark traded at levels below -0.8 percent (Chart 1).
What has been happening here? Of course, part of the explanation is that German bunds are seen as having the highest credit quality and being the most secure bonds in the event of instability or even in the event of a Eurozone breakup. And shorter-term bonds typically have far lower price volatility than longer-term bonds. So, for very risk-averse Eurozone investors, two-year German bonds, even at yields far into negative territory, might be the investment of choice. This is the so-called “flight to quality” in its most extreme form.
However, another part of the explanation is that German bunds, especially at the very short end of the yield curve, could be victims of an unintended consequence of the ECB’s bond-buying program. In many parts of the Eurozone bond market, the central bank has been confronting the issue of “bond scarcity”—the fact that there are simply not enough bonds to buy. Until the December 8 Governing Council Meeting, the ECB’s bond-buying program operated under the self-imposed constraint that it would not buy bonds at a yield below the ECB’s deposit-facility rate—currently -0.4 percent.
As Chart 1 illustrates, these very short-maturity German sovereign bonds had been trading below that deposit facility cutoff level for all of 2016, despite the fact that they were ineligible for ECB purchases. This fact points to another source of demand for this paper: from banks and securities firms that require top-quality—and preferably short-maturity—government bonds for use as trading collateral. Collateral shortages already were causing tightness in Eurozone money markets in late 2016. When the ECB decided to allow bond purchases at yields below the deposit rate on December 8, this situation was exacerbated, and Eurozone yields fell even further.
In short, despite the general rise in yields for longer maturities, three overlapping sources of demand have meant that two-year rates are still plumbing ever more extreme negative levels. These three sources of demand—investor demand for (perceived) safety, trader demand for collateral, and ECB purchases since January—are unlikely to weaken anytime soon, so we expect two-year Eurozone bond yields to remain extremely negative for the coming months—at least until political concerns in the currency bloc start to recede.
What It May Mean for Investors
Why would the two-year German bond yield matter to investors, especially those that do not take exposure in the form of individual securities? One reason is that short-maturity bond yields are closely related to the strength or weakness of the currency. As short-term German yields are reaching new lows, two-year U.S. Treasury yields have been rising, as investors speculate on Federal Reserve (Fed) rate increases this year. The two-year U.S. Treasury-German government bond yield differential has widened from 140 basis points at the start of November to beyond 200 basis points currently. As Chart 2 suggests, this differential is one factor that can strongly influence the movement of the euro/dollar exchange rate.
We expect that the euro will fall against the dollar from its current level of above 1.06 dollars per euro to around parity (1.00 dollar per euro) by the end of this year. This is in part due to our expectation that political concerns around populist contenders in elections in Holland and France (especially the latter) will worsen further before possibly improving later in the year. Yet our view also is based on the current divergence between Fed and ECB policies. Although downward pressure on German two-year rates may ease somewhat, we expect the wide two-year bond differential to continue to weaken the euro even if political worries recede. It will be important to follow the whole yield curve—the short end as well as the 10-year maturity—in order to monitor this view as the year progresses.
Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.
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