Thursday, April 30, 2015

Is this the end of the Bund bull market?

Fundamentally, Bund yields have fallen too low and should move higher over the remainder of this year. The move lower in recent weeks has been purely flow-driven to speculate on higher prices amid a negative net supply given the ECB’s QE purchases and due to the status of Bunds as a safe-haven in light of fears of an imminent Greek default. As Greek default risks have receded somewhat and consensus as well as positioning seems to have become heavily tilted on the bullish side, it seems likely that the lows in 10y Bund yields are already behind us.
First, The Eurozone growth outlook has been improving and growth should rise markedly over the course of this year, likely hitting approx. 2.5% on an annualised basis before year-end. While structural challenges remain, cyclical forces are adding up to a very strong growth tailwind. The weak Euro, low oil prices, reduced negative growth effects from fiscal tightening, record low nominal and real yields – at last also in the periphery – as well as a turnaround in credit creation all act to lift growth. Moreover, amid the time lags involved, the positive impetus will get ever stronger in the months and quarters ahead. Business sentiment has improved noticeably since late last year and can improve further.  
Not only has real growth moved on an upward path, but also the three years’ long disinflation has ended and headline inflation rose already from –0.6% to 0% in April. The chart below shows the Eurozone yoy inflation rate and divides it into three components. Commodity price effects are marked in green (defined as the difference between headline and core inflation), fiscal policy effects in red (derived from changes in consumption taxes and prices for administered goods and services) and the residual in blue. This residual can be thought of as the underlying price pressures emanating from the private sector. As can be seen, disinflation was mainly caused by falling commodity prices. Also a reduction in the price effects of fiscal policy from 0.7% to only 0.1% in March was an important driver. Underlying price pressures fell as well, from 1,0% at the end of 2011 to 0.1% in May 2014 with likely the strong Euro (reaching its high in March last year) being responsible for approx. half of this drop. However, these underlying price pressures have increased already and have risen to +0.5% yoy last month. Core inflation of 0.6% in April – matching the record low of January and March – masks the slowly increasing underlying price pressures amid a reduction in the price effects of changes in consumption taxes. As a result, not only headline inflation is likely to move noticeably higher in the months ahead – as oil prices have started to recover – but also core inflation can rise moderately into year-end. 

Eurozone inflation: Underlying inflation pressures have already increased (data until March)
 Source: Eurostat, Research Ahead

This combination of substantially rising real growth from below trend to markedly above trend and inflation moving back into positive territory will exert increasing upward pressure on bond yields as the year progresses. What is more as these economic developments take hold doubts that the ECB will maintain its ultra-easy monetary policy stance until at least autumn 2016 and speculations that it will taper purchases and/or might increase the negative depo rate back to 0% before that time should become increasingly stronger.
Moreover, the rising uncertainty with respect to Greece and the threat of an imminent default have also supported the safe haven of German government bonds in recent weeks. The support provided by the latter has gone into reverse, however. The Greek government introduced a bill which forces municipalities and state enterprises to transfer their cash holdings to the central government providing it with the necessary liquidity to fund upcoming loan redemptions. In addition, over the past few days PM Tsipras has reshuffled the Greek negotiation team, reduced the power of finance minister Varoufakis, suggested a new list with reforms and hinted at a possible referendum for the public to decide whether they accept the necessary reforms in order to secure a new bail-out and stay in the Euro. All this has reduced the imminent default risk and thus also the support for Bunds.  
Furthermore, ever since the ECB decided to engage in large scale asset purchases in February, the main argument for buying Bunds was the negative net supply on the back of large ECB purchases and a balanced budget. This lead to a bull-flattening of the curve as investors piled into this shrinking asset class. However, such a flow driven rally leads valuations ever further away from fundamental developments (which as stated above suggest rising yields). With the bullish sentiment becoming dominant and positioning likely tilted in favour of longs, the additional buying by speculative accounts dries up whereas the fundamentally driven accounts as well as life insurers and pension funds have already moved to the sidelines amid too low yields and expensive valuations. As a result, buying dries up – barring the ECB/Bundesbank - and it does not take a lot to cause a wave of profit taking.
Finally, the technical market backdrop for Bunds has deteriorated. As the chart below shows for 10y Bund yields, stochastics have turned higher from oversold territory. In addition, the downward trend in place since September last year (which was fuelled by QE speculation) has been broken to the upside which provides a first bearish technical signal. This still leaves another downward trend in place since the start of 2014 (which started on the back of disinflation and weak growth). However, this more important longer-term trend running at slightly below 0,40% needs to be broken first to render the picture outright bearish. Still, over the past twelve months lower Bund yields have dragged longer-dated UST and Gilt yields lower. Now, the relationship has changed and higher UST and Gilt yields (which are already up by approx. 40bp and 50bp respectively since their lows at the end of January) start to put upward pressure on Eurozone yields.

Downward trend in 10y Bund yields in place since September has been broken to the upside

 Source: Bloomberg

As a result, I regard Bunds as fundamentally expensive and expect the fundamental fair-value for yields to increase as the year progresses. The ECB’s purchases will continue to keep Bund yields below any estimate of fair-value, however. Still the upward pressure on yields should intensify during summer and I believe that the yield lows are already behind us and the long Bund bull market has ended. The process of a gradual duration reduction in Eurozone bond portfolios can continue.  

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