Growing up, growing apart
As the economic recovery gathers steam, expectations of rising interest rates have pushed up sovereign bond yields. But the varying speeds of rebound across the developed world have led to a divergence in yields. What are the implications for investors in sovereign debt?
To see the digital version of this report, please click here.
To purchase printed copies or a PDF of this report, please email email@example.com.
In normal economic times, it is the direction of official interest rates and market expectations of their next move that are the primary factors driving sovereign bond prices and yields.
So when central banks across the G7 slashed their policy rates to close to zero to avert a global depression, investors piled into bonds of countries seen as safe havens and fled those seen as serious default risks. Interest rates got pushed to the back of traders’ minds.
But over recent months, the future path of interest rates has moved back to the top of the agenda as it has become clear that different regions and countries within the developed world are moving at different speeds with regards to ending their stimulus efforts.
“We are clearly in a world where the [US] Fed is on an exit path, the Bank of England is on an exit path, the Bank of Japan will do more and the euro area sits somewhere in between,” said Michala Marcussen, global head of economics at Societe Generale.
At the same time it has become clear that different countries are enjoying a range of types of economic recovery. Add into that cocktail a potent dash of geopolitical crisis and the result is increased market uncertainty.
This has led to major moves in bond spreads whether between the economic powerhouses of the US and the eurozone and/or between different countries within Europe.
One noticeable phenomenon has been the widening of spreads between 10-year US Treasury bonds and German bunds as yields on US paper have risen faster than those in the key eurozone economy.
The spread has widened from around 60bp in the autumn to an eight-year high of 116bp in March. One forecaster, Capital Economics, forecasts spreads of 150bp by the end of this year
Anthony O’Brien, co-head of European rates strategy at Morgan Stanley, said the spreads were where he would expect given the economic outlook. “Is it too wide? There’s quite a bit packed into Europe’s bund yields,” he said. ”An awful lot has gone into depressing yields in Europe.”
Markets believe the Fed will move to increase rates sooner rather than later, while the ECB, despite its perceived hawkishness on inflation, will delay following, and might even cut rates. So unless there is a significant event or policy shift from either side, US yields are likely to continue leading those of bunds.
“The US is far more advanced in the current cycle than the eurozone,” said Christian Schulz, senior economist at German bank Berenberg. “Clearly you would expect the Fed to raise rates ahead of the ECB but I would say that the Fed is less hawkish than the ECB.”
Noting the unexpected comment – or gaffe – by Fed chair Janet Yellen at her inaugural press briefing in March when she indicated that the first rate rise could come six months after the end of the tapering process, Schulz said there was no doubt about the hawkish noises emanating from Washington. But he added: “The ECB has a tendency to raise rates earlier than the Fed, so I would not expect the ECB to tighten much later than the Fed.”
One fear at the back of credit strategists’ minds is whether the eurozone could follow the path of Japan in the 1990s, when JGBs dislocated completely from Treasuries.
“If you think that the eurozone has some deflation risk, there’s a possibility you could see that dislocation,” said Ben Bennett, head of credit strategy at Legal & General Investment Management.
These fears were heightened after data for March showed eurozone inflation dropping to 0.5%. Bennett said that one reason was that the eurozone was using structural reform to reduce deficits, which led to lower wages and higher unemployment and that led to banks deleveraging. “All these factors are deflationary,” he said.
With most commentators confident that US yields have priced in the tapering of QE and likely rate rises, one surprise is why rising geopolitical risks in the wake of the Ukraine crisis have not compressed Treasury yields from rising as investors seek safe havens.
“You would have thought that Treasuries would benefit more than bunds from the [Ukraine] uncertainty. It seems that bunds have been performing quite well,” said Steve Major, global head of fixed income research at HSBC.
Schulz said the Ukraine crisis showed how German debt continued to act as a bolt-hole for SSA investors. “German bunds are a safe haven, have always been a safe haven and, given how strong [Germany’s] economic and fiscal position is, remain a safe haven,” he said.
“Whenever there is a crisis anywhere in the world, be it in Russia or emerging markets or a currency crisis, German bunds will always benefit.”
But while Germany also acted as a safe haven during the eurozone during the crisis, that dynamic is likely to weaken. “The peripheral countries’ spreads over safe haven bonds have come in dramatically,” Schulz said.
Rising confidence in the eurozone recovery has bolstered strong demand by investors for peripheral country debt. Spain, which was upgraded to Baa2 by Moody’s in February, sold €2.7bn of five-year debt in March at a yield of 1.991%, its lowest on record.
The same month saw neighbouring Portugal find demand outstripping supply of new one-year bonds by two to one, pushing the yield to an eight-year low of 0.6%, while Italy achieved a euro-era low in a 15-year bond auction and Ireland hit its €1bn target at its first bond auction since it sought a bailout programme in 2010.
“There have been dramatic reforms in many peripheral countries that means those economies are now in a much better shape for future growth than when they were going into the crisis,” said Schulz.
O’Brien said he has seen more real-money investors in Italy, Spain and the other peripheral countries. “If you are a European investor who invests in euro-denominated debt, as long as you are happy with the risk of the periphery, you are picking up substantial amounts of carry and of yields over bunds, so BTPs and Spain will be part of your portfolio,” he said.
“In a search for a yield environment where people’s base-case scenario is that we don’t get any more eurozone blow-ups, picking up the high yields offers a decent return.”
Ten-year yields of many peripheral countries are now between 3% and 4% in the secondary market – a range many forecasters expect the Fed to occupy by the end of the year.
Marcussen, who said it would be “logical” for Treasury yields to reach 3.65% by year-end, posed a rhetorical query. “Ask yourself the question: would I rather have 3.65% in the US or in Spain?”
She said that much of the yield compression had been driven by the ECB’s Mario Draghi’s pledge to do “whatever it takes”. ”So as long as there is no crisis we are fine,” she said. “If a new crisis strikes the euro area, we are not in a very strong position to tackle that. A lot of the vulnerabilities will be exposed.”
The geographical distance between the UK and Continental Europe may be tiny but the distance in yield is dramatic. The gap between Gilts and bunds reached a 16-year high in March, widening to 118bp – the highest since September 1998.
In contrast, the UK and US seem to be in a long-distance relationship, with the spread recently being as little as one or two basis points. “We could be global guinea pigs for higher interest rates,” said Bennett at LGIM. “The UK could possibly be the first central bank to raise rates in the cycle. It could be a test of what happens when rates go up.”
He said he was optimistic that the UK would cope with higher rates, a view echoed by Marcussen.
O’Brien at Morgan Stanley said there was a “certain amount of belief” that central banks would raise rates “slowly, cautiously [and] over a prolonged period”.
“They are not going to hike rates as they did in, say, 1994 so a lot of caution will be shown by central banks,” he said. ”They have already talked about the normal rate of interest being lower than it has been in the past.”
If so, investors can breath a sign of relief – for now at least.