Tuesday, August 21, 2012

Life in the negative real yield environment

The key issue I cover in my latest economics & fixed income strategy publiction is the trend towards negative real yields on an increasing range of assets. In the period of 1982-2009, the great bond bull market in the US was driven largely by lower inflation. Since 2010, however, the bond bull market has been almost exlusively driven by lower real yields.
Also in the Eurozone, the ECB is orchestrating a negative real yield environment for an increasing number of assets (first on Bunds, then the semi-core markets and now the periphery and with that essentially on all carry products). Negative real yields not only provide an easy monetary environment but they also help to lower debt-GDP ratios over time. Contrary to popular opinion, high inflation rates are not a necessary condition to lower debt-GDP ratios. As long as deflation is averted ultra-low nominal bond yields provide for the necessary low/negative real yields. For the deleveraging economies with increasing sovereign debt, this provides the easiest way out of the financial and economic crisis in an environment where nominal GDP can only grow at low rates (amid low trend growth and amid low inflation rates in a deleveraging economy).

This trend is far from over and negative real yields in the deleveraging economies will be with us for the rest of this decade.

The presentation can be found here: "Life in a negative real yield environment".

Tuesday, August 7, 2012

The new ECB takes shape

Following a long and amazing vacation in the US with my family, I am now back in Frankfurt. When we landed at the airport we had a good view of the new ECB tower which is being built in the East end. Looking at the construction site it reminded me of the current state of the Eurozone (see picture which is dated August 2nd): 
1. the North tower is taller
2. the South tower is shorter
3. they are only loosely connected with a large gap in between
4. it is far from finished but at least it is progressing

Just as the new ECB headquarter is being built, ECB president Draghi has also been transforming the ECB from a Bundesbank-like institution into a more interventionist central bank. First he changed the Trichet-dogma that the dependency of banks on central bank liquidity is bad and should be minimised when he introduced the 3y LTROs and at the same time eased collateral standards. Now he has performed another very significant step with the announcement that the ECB intends to buy short-dated sovereign bonds from those countries applying for help from the EFSF/ESM. I regard this as a very meaningful step with huge implications. So far, the ECB has done everything to keep solvent banks liquid (it is within their mandate to finance the banking system). However, they have been very reluctant to go down the same path for sovereigns. While it is not yet clear in what size and at what terms etc. the ECB will intervene and certainly the sovereigns first need to apply for help from the EFSF/ESM, with last Thursday's announcement the ECB will effectively do similar things for sovereigns as for banks and keep solvent sovereigns liquid. Again, it is in the political realm to keep sovereigns solvent (as it is with the banks) via austerity measures, structural reforms and the EFSF/ESM.

The ECB tries to break the negative feedback loops 

Source: Research Ahead 

Buying sovereign bonds even if only short-term ones sends a strong signal that the ECB is determined to do what it takes to keep the system afloat. Furthermore, even if they only start with buying bonds up to one year, this should have implications across the curve. Buying short-term bonds should reduce the yields on those instruments significantly and hence lead to a much steeper yield curve for Spain/Italy. In turn, the roll-down available via investing in longer maturities increases and coupled with 0% yields on 2y core and semi-core governemnt bonds provides strong incentives for investors to - in a second phase - extend into longer-dated bonds as well. Furthermore, once the central bank has taken the step to buy government bonds, it should be easier to take the decision to broaden the maturity bucket of the bonds being bought.

Economically, it helps to ease one the various negative feedback loops which are present in the Eurozone (see chart) as it lower interest costs for the sovereigns in question which helps to lower the deficit as well. This should also have positive effects on the domestic banks which hold a lot of the sovereign bonds and should see their balance sheets strengthen while their own access to credit markets should improve somewhat given the more favourable terms of the sovereign.
On another note, this reduces the problem of the limited capacity the EFSF/ESM have and hence should for the time being put an end to discussions about granting the ESM a banking licence or increasing its size, a discussion which in the northern Eurozone countries has not been welcomed.

Assuming, that the ECB will indeed do what it announced (and also address the seniority issues of the bonds it buys), the Eurozone has bought itself quite a lot of time and I expect the market reaction to be similar to the one following the introduction of the 3y LTROs, just a bit longer lasting. To be more precise, I expect Bund yields to move into a range-trading mode with a slightly steeper curve. I maintain my view for an ongoing outperformance and convergence of the semi-core markets with Belgium remaining my favourite. In general, nominal bond yields should drop to very low levels and credit spreads should tighten as the systemic risks have once again been reduced while at the same time, nominal growth remains weak. Yields on short-to-medium term Italian and Spanish bonds should drop further over the next few months whereas their yield curves should steepen. Risky assets in general should be underpinned and as a result, meaningful retracements should be used to increase exposure.