Jon Jonsson (pictured), senior portfolio manager, Global Investment Grade Fixed Income at Neuberger Berman argues that although European government bond yields bear little relation to economic fundamentals, zero-weighting or short selling them is a risky option.
The European Central Bank president’s latest press conference was not a market-moving event but it did not lack excitement. Most memorable, perhaps, was the young woman who showered Mario Draghi with confetti while decrying an “ECB dictatorship.” Did she mean that the central bank is “dictating” European government bond pricing? If so, our Global Investment Grade Fixed Income team would probably agree.
Lower Than Low
Yields have been low for months but the week before the press conference on Wednesday, April 15, saw some real milestones: Switzerland auctioned 10-year bonds at a yield of -0.06% and, for a while, even Spain’s two-year bonds traded at negative yields, having approached 7% three years ago. Germany’s yield curve is negative out to seven years. As an indication of the breadth and extent of the collapse in yields, consider Portugal’s bond maturing in October 2016: Just three years after breaching 20%, its yield is also flirting with zero.
In our view, technical forces are the key drivers behind the low yields. The ECB has committed to a €1 trillion-plus quantitative easing program over the next 18 months. When the Federal Reserve conducted its QE programs, the U.S. was running massive deficits and the Fed bought less than half of an abundant supply of bonds. Deficits are much smaller in Europe and the ECB is buying all the new supply and more. That makes the impact on bond yields much more dramatic. The ECB’s decision to purchase long-dated bonds explains the substantial flattening of eurozone yield curves as well.
Disconnect from Fundamentals
A look at the recent trading levels of credit default swaps (CDS) reflects the dominance of technical factors over fundamentals in current pricing. European bond yields have been roughly 30-70 basis points below corresponding CDS spreads everywhere except Greece—in contrast to their typical trading range above swaps. Given that CDS are viewed as more reflective of credit risk, they suggest a relatively positive picture that would be seen in bonds yields if not for quantitative easing.
Indeed, while there is clearly risk associated with Greece, the combination of QE and a weaker euro is already improving growth and financial conditions. As Draghi noted in his press conference, the M1 money supply has climbed steadily over the past year (Figure 2). Historically, this metric has led GDP growth by about 12 months. Backed by a robust pick-up in lending to households and corporations (Figure 3), the eurozone recovery seems at odds with what is priced into its government bond markets.
Wary but Not All Negative
Despite the disconnect between prices and fundamentals, we believe there is currently built-in demand for government bonds that should make investors wary of substantially underweighting or selling short low or negative-yielding bonds without having offsetting positions.
A small portion of the market is likely to buy these bonds speculatively, anticipating yields falling even further into negative territory. Demand may also come from European banks, which need them as high-quality collateral (although Draghi’s commitment to keeping the ECB deposit rate at or above -0.2% may incentivize them to hold cash in the event of yields breaching that level). Passive index funds naturally will also continue to buy and even active managers with tracking error constraints are likely to avoid underweights that could generate risk while adding zero alpha. Then there are the pension funds and insurance companies that need the bonds to match liabilities or meet regulatory requirements.
Moreover, with the ECB likely to err on the side of caution before winding up QE, even if our core scenario of improving growth and inflation materializes, eurozone bond yields may not rise immediately, and indeed could fall further.
With yields at extreme lows even as technicals threaten to maintain current momentum, we think it is important for investors not to restrict themselves to binary choices—such as going long or short a particular country’s bonds. Rather, we believe in embracing a range of relative value opportunities. For example, one could short core eurozone paper against longs in other markets that could also benefit from the downward pull of core yields; those shorts could then potentially deliver positive results when European markets eventually return to pricing in economic reality. The point is to maintain flexibility and to take opportunities where and when they arise—something that can help investors seek return in the current ungenerous interest rate environment.