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.