German government bonds recently sold off sharply, to the current 70 bp in the 10 year part of the curve, after having rallied to a low of only 8 bp in April. The selling that started in Germany also spilled over to selling of longer dated government bonds globally, including US Treasuries and Gilts. Back in mid-April, a combination of ECB QE purchases and no new supply from Germany (who will run a small budget surplus this year) led people to ask when the yield on 10 year Bunds might turn negative, rather than when Bunds might sell off! Of course, Greece was a potentially disruptive threat, and it was also less clear that core inflation was close to turning up in Europe.
So what has gone so wrong? Or perhaps, I should ask what has gone so right? After all, the sale of risk free assets, the lifting of inflation expectations and a move in favour of risky assets are “textbook” responses to QE, as this was what happened following similar programmes from the FOMC and the Bank of England.
Government bond markets have been driven by central banks ever since the early days of the financial crisis. Don’t fight the Fed became don’t fight the Bank of England, the Bank of Japan and the European Central Bank. We must not forget this mantra. But whilst central banks have close to total control of the short end of the yield curve, the market has more of a say in the longer end.
The market is now saying that the “term premium” that has held long end yields down went too far, and this is what is being re-priced.
There are a number of factors why the market now thinks the term premium had overshot. Eurozone growth is picking up to a growth rate of about 1.5% in 2015, a touch above trend. Inflation globally has also turned, thanks to the recovery in oil but also thanks to forceful action from more than two dozen central banks, including the PBoC who have shown that they will put a floor on China’s growth. So, global growth and inflation are not going to fall off a cliff after all! Meanwhile, investors were increasingly moving into crowded positions, extending further out the curve or down in credit due to the sheer weight of money that was being created by central banks, as well as the need to find some incremental yield. At the short end of many Eurozone curves, yields had dropped below zero. Money started flowing out of low yielding Germany (and Japan) into higher yielding countries including the US, UK or Australia. However once selling began, crowded positions and poor liquidity combined to exacerbate the price action with Bunds currently friendless, apart from the ECB of course.
What will turn the weakening bond market around now? Even at 70bp, 10 year Bunds still look rich. Again we need to go back to the “textbook”. Bunds may remain under pressure until we see some combination of higher yields causing growth indicators to slow down, risk assets starting to take fright, bank lending slow, or the euro starts to rise, thereby stalling net exports growth. Until then, we do not want to fade this move in Bund yields. Instead we prefer to position for this repricing of the term premium in a couple of ways. We are underweight Germany against an equivalent overweight in other developed markets in the 30 year part of their respective curves. Since the global sell-off was made in Germany, we prefer to be underweight the market that is driving this move. In addition, we are also positioned for the curve to steepen and are underweight 30 year bonds against overweight 10 year bonds in Germany. These strategies allow us to position for the re-pricing of longer end yields which may well continue, without taking on the might of the ECB.