October has been a bad month for bond markets. German Bunds have risen 30bps, making it their worst month since 2013, whist US Treasuries have climbed to their highest levels since May 2016.
We have heard numerous reasons for the sell-off, and address some of them below:
- 1. Increased probability of a Fed rate hike in December (now 73%) – the recent economic data in the US (and globally) has been just about strong enough to allow the Fed to hike in December and not, in our opinion, upset markets.
- 2. All about inflation breakevens – real rates haven’t moved. In the major markets, the majority of the recent sell-off can be attributed to a rise in inflation expectations, due to the increase in the oil price over the last 12 months.
- 3. Stronger UK data sees market pricing next rate move as a hike – as mentioned below, Q3 GDP data in the UK was sufficiently strong to make the market consider that further rate cuts may not be needed.
- 4. Euro OverNight Index Average (Eonia) no longer pricing in rate cuts – as in the UK, recent strong economic data in Europe (better IFO survey data and German Industrial Production numbers), along with increasing inflation makes it unlikely that the ECB would cut the deposit rate further.
- 5. Stretched positioning – data from the Eurex futures exchange and anecdotal evidence from counter-parts suggest that many investors were long duration. The cutting of these positions as bond yields rose exacerbated the selling pressure.
- 6. Bond volatility had been close to historic lows – the Merrill Lynch Option Volatility “MOVE” index showed bond market volatility had moved back towards the very lows levels seen in May 2013 and August 2014. In both cases, volatility rebounded sharply higher shortly afterwards.
Whilst we have some sympathy with the move higher in yields, and are running a short duration position ourselves in Europe, we don’t subscribe to the belief that this is the start of another “taper tantrum”.
UK – Moving towards a “Dirty Brexit”
We seem to spend a lot of time writing about the UK, sterling and the UK bond market, but that’s because it constantly remains in the news, and is a “hot” topic for markets.
Last week, there were three more interesting news stories that caught our eye. The first was a comment from Bank of England (BoE) governor Mark Carney noting that there were “limits to the Monetary Policy Committee’s (MPC) willingness to look through an overshoot of inflation”.
This was regarded as a mildly hawkish statement, as previous statements had indicated the MPC expected sterling’s recent depreciation to be the cause of higher inflation prints, and therefore not requiring a monetary policy response.
Secondly, there was some brief, but unbecoming, speculation that BoE governor Carney might be forced to resign or step down, in light of recent criticism of his alleged “scaremongering” about the effects of Brexit and the BoE’s recent monetary policy actions. This was resolved when Carney announced that he would stay in his role until June 2019, slightly longer than his initial indicated 5-year tenure.
Finally, but probably most importantly, Q3 GDP numbers for the UK published last week showed the economy to have grown by 0.5% quarter-on-quarter, stronger than the market’s expectations for 0.3% growth. This suggests that the UK economy is holding on quite well in the immediate aftermath of the Brexit vote. In turn, that suggests to us that the MPC could sit on their hands at their upcoming meeting, and leave rates unchanged.
There was also an interesting snippet of news from Nissan, who pledged to keep manufacturing motor vehicles at their Sunderland plant, the country’s largest car factory. This immediately drew questions as to what assistance the UK government may have promised to keep Nissan from shutting their plant. Maybe it’s a sign of the way things could develop post the triggering of Article 50 in March 2017. The inability to complete bilateral trade deals in the two-year period until the UK leaves the EU in 2019 may see similar deals done with other economically-important sectors, leading not to a ”soft” or “hard” Brexit, but a “dirty” Brexit.
Ultra long-dated bonds – What’s the attraction?
Another first for the European government bond markets last week saw the Austrian government issue €2bn of 70-year maturity bonds.
With yields at such low levels, it certainly makes sense for governments to lock in these borrowing costs. But with a duration of 43 (yes – 43!!) according to Bloomberg, the effect of a small rise or fall in yields has a huge effect on the price of this bond. So despite the fact that the bond is outperforming other long-dated issues (it was issued at a spread of +52bps to the current Austrian 30-year maturity, and now trades at +42bps to the same bond); in absolute terms it’s suffered badly from last week’s rise in global bond yields. It was issued at a price of 97.002, and today trades at a price of 93.70 – a loss of 3.5% in one week!
But it’s not just Austria that’s issuing very long-dated bonds – both Belgium and Ireland have already issued 100-year bond in 2016, albeit to a single purchaser in private placement deals.
And the duration on the Bank of America Merrill Lynch Global Government Bond index has reached a level of 8.17 at end-September 2016, up from a level of around 5 when the index started in 1997.
But the attraction of these long-dated bonds lies in their convexity, which is a second derivative of duration. If the yield of the Austrian 2086 bond were to rise by 50bp, the price will drop by about 17 points (say from 97 to 80). However, if its yield were to drop by 50bp, the price goes up by 23 points (say from 97 to 120).
The second attraction of these bonds is that they offer some protection to the eventual end of the ECB’s Private Sector Purchase Programme. As the ECB only buys bonds with up to a 31-year maturity, the curve beyond 30 years remains rather steep. This part of the curve should flatten when the ECB eventually start tapering their bond buying.
We believe these bonds have their natural home in continental asset liability management books, where they are probably locked away and held for a very long time. However, there is only so much true demand for such ultra-long paper from these accounts that this is likely saturated for the near-term. We understand the temptation of various debt management offices to lock in ultra-long rates at historically low levels, but they should not overestimate the true demand for this paper.
Tanguy Le Saout is head of European Fixed Income at Pioneer Investments