What’s driving bond yields up?

The ECB has been delighted with the response to its asset purchase programme, and indeed the initial reaction from  all asset classes, from bonds through to equities and FX, was both significant and supportive of the Bank’s attempts to stimulate economic activity. The ECB first announced its intention to buy  private sector debt last September, with the euro trading at $1.29, and the single currency subsequently declined to under $1.05  following the January decision to extend QE to government bonds and the  commencement of purchases  in early March. European stock markets rose sharply in the months after the January decision and bond yields continued the trend decline begun last autumn; Irish 10-year yields fell to a low of 0.65% and the German equivalent traded at 7bp, with negative yields prevalent in that market up to an including the 5-year maturity.

The picture looks rather different today.  Government bond yields have risen sharply amid very volatile trading, with 10-year yields in most markets back up to levels seen last October. German  4 and 5-year yields  are now positive again  and the major European equity markets have fallen by around 10% from the highs, with the euro also gaining ground, trading above $1.12.  QE is still  proceeding according to plan and the ECB’s balance sheet is expanding as intended ( €2.42 trillion at end- May from €2.15 trillion at end-2014)   so the fall in asset prices has prompted some  puzzlement, with  a number of  explanations vying for supremacy.

One approach emphasizes  bond  fundamentals, starting with real interest rates and the outlook for economic growth. The  macro data in the euro zone has tended to surprise to the upside in recent months and there was some modest upward revisions to near-term growth forecasts  but the consensus projections for the next few years have not really changed, with most still expecting a sub 2% expansion in the EA.  Similarly the outlook for the global economy has not materially changed (if anything,  the growth forecast for this year have moved lower) so it does not seem likely that real interest rates have suddenly moved higher.

Nominal bond yields are also determined by  inflation expectations (plus a risk premium) and again  forecasts  for EA inflation have not materially changed of late, including those from the ECB,  which foresees a gradual return to annual inflations rates approaching 2%.  Actual inflation has turned positive, it has to be said, so perhaps the deflation scare has abated, although it was always difficult to know if that was really a major concern for investors. Expectations on one of the ECB’s most closely watched measures (the 5 year five year forward inflation swap) are  around 1.75%, which is well up from the sub 1.50% lows but not signaling any inflation scare.

Some peripheral bond markets have fared worse than others during the sell-off  (Portugal for example) but a generalized contagion from Greece is not evident, at least not yet, given that 10-yr bund yields  have also risen sharply, by over 80bp in the past 6 weeks.

Other explanations emphasis market conditions. Issuance in some markets has been higher than expected, for example, including corporate debt. Lack of liquidity may also be  a factor, as a consequence of banks having to hold more  regulatory capital. This , alongside the Volckler rule, has persuaded many market-makers to hold less inventory, with the result that a given degree of selling will have a much greater impact on the market price than it would have done a few years ago. Certainly the scale of intra-day volatility (up to 16bp in 10-year bund yields) is far higher than normal, supporting the idea of thinner markets.

Another  explanation highlights the different types of bond buyers, each with varying risk  tolerances and trading objectives. Banks are required to hold more liquid assets under new Basel regulations, and  so  have bought shorter-dated bonds even at negative yields , particularly as for some the alternative is a deposit with the ECB at an interest rate of -0.2% (overnight ECB deposits are still high, at  €100bn). Credit conditions are improving in the EA, however, with a modest pick up in lending to the private sector, so  some banks are finally using the ample liquidity available to support credit creation to firms and households.

Hedge funds and other traders are looking for a short term return and here the predominant  trading style may be a factor- momentum trading is the order of the day for many, which explains why a trend already well established can persist long after some feel it has lost touch with fundamentals.  The problem arises when the trend  changes and many are then heading for the door, which is suddenly crowded. The lack of liquidity  is exacerbating the downdraft.

‘Real money’ investors, such as pension and insurance funds, are also important, but usually ‘buy-to-hold’ and generally players at longer maturities. They are therefore  less likely  to get caught up in a specific trading style and may well step in following a sharp  sell-off, so putting a floor in the market.

All these explanations, fundamental and market related, are not mutually exclusive, of course, and I suspect the sell-off owes most to the  recent inflation data and the acceleration in monetary growth, with the exit from a crowded trade also playing a big role. One should also keep the correction in perspective- bond yields (government and corporate ) are still extremely low by normal standards and hence  nominal financial conditions  remain unusually  loose, even if a little tighter of late.  In the shorter term it may well be  the actions of  the Fed, rather than the ECB, that helps determine the next big move in EA yields.

Falling Prices versus Deflation

Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2%  Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the  euro  inflation rate  towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?

Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity  prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts  envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.

If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case  against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than  half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in  the CPI would probably in turn require a prolonged and heavy  fall in wages. Ireland has seen a  modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts)  while wage growth is positive on average across the euro area.

The performance of  euro equity markets would also suggest that deflation is not a base case,  and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices  next year. Deflation will also  affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.

The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond  yields)  popular as they can be monitored in real time. On that basis the US market is expecting inflation  to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.

Evidence, then, that inflation is expected to be low and certainly below  the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.