Interest rates saw sharp swings in 2013.
10-year Bund yields fell as far as 1.15% in May 2013, close to their historic low, and then tested the 2% level first in September and again by year end, driven by market talk about the tapering of the asset purchase programme by the US Federal Reserve. After the tapering plans were confirmed, yields fell back again. The drop to near their historic low again since the beginning of this year looks astonishing. This volatility does not contradict our view that yields will stay low for the next few years. Despite more than a year of growth in the eurozone, the ECB has responded to the threat of deflation and is fighting a possible negative spiral in the real economy. Its actions acknowledge that the recovery is still fragile and that the eurozone economy remains quite fragmented.
It appears the downtrend in eurozone inflation has not yet stopped. For the third time since December, headline inflation was a meagre 0.5% YoY in June; core inflation was close to its historic low of 0.7% YoY. Against this backdrop, the controversy over the likelihood of deflation in the eurozone is unlikely to cease anytime soon. On the one hand, inflation reflects factors that could be seen as temporary: ranging from wage cuts to the regaining of competitiveness in some countries to falling energy prices and the strength of the euro. This does not have to end in a process of permanent falls in prices, i.e. in deflation. However, the cushion of protection against the effects of an additional negative shock that could trigger a plunge into deflation is thin. Deflation would have a detrimental impact on still high debt burdens.
Figure 1: Eurozone inflation “too low too long”
Figure 1 does not yet show a de-anchoring of inflation expectations, but the reaction to the downtrend in inflation is clear. In several recent reviews, ECB staff have lowered their projections for inflation and the period during which inflation is likely to remain clearly below the ECB target has been extended to the end of 2016. At the June policy meeting, the ECB opted for a change in policy to preserve the growth outlook and fight the build-up of deflation expectations (“The governing council is strongly determined to safeguard this anchoring [of inflation expectations]”). The latest ECB package put a strong focus on improving the monetary policy transmission mechanism and financing conditions for small and medium-sized enterprises (SMEs). In a world of deleveraging and still-fragmented financial markets, this should reduce the risk of a credit crunch.
Even after the June meeting, the difference between the ECB approach and that of the Fed remains striking. The Fed opted for a proactive stance, minimising any deflation risk by frontloading measures and moving relatively quickly to quantitative easing (QE). The ECB has a much slower reaction function, first analysing the response of the economy to previous action. The ECB is now weighing the possible risks from too loose monetary policy for inflation and the costs of an unlikely adverse scenario with a build-up of deflation expectations. It has also been taking into account the still-distorted transmission mechanism, which is a big obstacle for getting a homogenous response across eurozone countries to ECB policy action.
The time needed to implement the latest measures and assess their effectiveness looks likely to be at least a few months, but QE remains in the ECB tool kit (“if further action is needed”). It is positive that unemployment has started to decline (see figure 2). ECB action and its willingness to do more “if needed” should keep the yield curve steep and hold capital market yields down in the eurozone.
Reducing the huge output gap in the eurozone is likely to be a frustratingly slow process. Figure 3 signals that monetary policy is accommodative and even some acceleration in growth can be expected, but a dynamic recovery looks unlikely. Currently, a cyclical impulse is driving growth, caused by the decline in uncertainty in the wake of the ECB’s successful fight against expectations of a eurozone break-up, pent-up demand from companies and consumers and the fading of headwinds from sharp fiscal consolidation. In the longer term, factors such as the need for deleveraging and poor demographics are likely to weigh on trend growth in the eurozone. As a result, the recovery pattern will likely lack the dynamic seen in the past and inflationary pressures should be limited.
On the domestic side, the case for low yields is quite well underpinned in our view and justifies low key rates for a prolonged period. There are reasons for a deflation threat, or a discussion about “Japanisation”, but we do not share these expectations. Just looking at a quite simple approach by linking yields to nominal growth, a prolonged period of low yields can be expected. At current yield levels and against the longer-term backdrop of modest growth and slightly higher inflation, Bunds would start looking expensive.
ECB action is a factor limiting the upward pressure on Bund yields, but what about the risk of rising capital market yields in the US? Tapering is on track and will end this year. Fed Chair Yellen surprised markets at her first news conference in January by mentioning the possibility of a first rate hike as soon as in the spring of 2015. Thereafter, Fed members have tried to tone down these comments. Yellen turned more dovish. She emphasised achieving full employment was a priority and regaining that is unlikely to happen before the end of 2016. Therefore the normalisation process for the fed funds rate will be much slower than in the past. Combining this with our view of lower trend growth in the US and GDP growth of around 2.5% in the second half of 2014, yield levels are, in our view, unlikely to rise sharply.
While the change in gears in US monetary policy should be smooth, we expect 10-year yields to rise towards 3% by the end of 2014, faster than currently embedded in interest-rate forwards. Nevertheless, the rise in yields should be limited over the longer term. The Federal Open Market Committee (FOMC) expects the fed funds rate to be at 2.5% by the end of 2016 and at around 3.75% further out. It has to be emphasised that in the coming months, yields could swing sharply on any Fed comments and macroeconomic news, as we saw in 2013. Discussions about whether the Fed is behind the curve and cross-checks with real data, especially on unemployment and wages, will likely dominate the headlines.
This has implications for duration policy: as yields creep higher, the earnings potential is reduced. Getting the volatility right will make the difference between positive or zero or even negative returns from investing in government bonds. Looking at current yields of around 1.2% for 10-year Bunds, we expect higher interest rates over the coming months, driven by the ongoing recovery in the eurozone, a fading deflation scare and the advent of the Fed’s first rate hike.
Forwards have more and more incorporated a low-yield scenario, but that seems currently overdone. Fundamentals do justify low yields, but a lot of positives have now been priced in, including ECB action, doubts over global growth and safe haven flows triggered by geopolitics. As a result, we see potential for higher yields in longer-dated debt. The setback potential is not that huge in our view, but volatility will probably accentuate any swings. Expectations of a gentle rise in yields should not be translated into a mechanically bearish view on government bonds. The steepness of the curve offers some reward for accepting volatility in yields in a low-yield environment, but it has declined in recent months. Structural demand for hedging liabilities (e.g. from pension funds) should support longer maturities.
When thinking about the shape of the curve, it is apparent that the ECB’s implicit pledge to anchor money market yields at low levels for longer has been reinforced by the broad package of measures announced in June.
So two-year rates should stay low as well. Tightening can hardly be expected before 2017. With the output gap closing only slowly during this recovery and a stubbornly high unemployment rate, the chances of this changing any time soon look slim. Add in that inflation is likely to remain below the ECB target for a long time and eurozone yields offer a cushion against adverse effects from the US. The ECB looks likely to be a laggard in the global tightening process. On a three-year horizon, we expect the 10-year over two-year yield gap to widen by more than embedded now in the forwards, while the spread between the 10-year and 30-year segment should flatten.