Moderate global growth but ongoing European & US upswing

Please find below a short summary of some structural themes and the building blocks for my medium term/2016 outlook:

1.) Trend growth rates have fallen in a large number of economies amid worsening demographics as well as lower productivity growth. Still, US trend growth (of currently around 1 3/4%) should be able to increase moderately amid slightly more favorable demographics and moderately rising productivity growth. 

2.) The Great Moderation 2.0 – the notion that macro-economic volatility has become lower on a structural basis – remains in play. Macro-prudential policies are adding to the reasons for an environment of structurally low macro-economic volatility in developed market economies. In turn, upswings will be more muted but longer-lasting, downswings should be milder and shorter. The current long but mild upswing in the US economy is a case in point. (For more see Macro-prudential policies and the Great Moderation 2.0)

3.) The commodity super-cycle has gone into reverse and weighs on commodity producers. A large number of important Emerging Markets and commodity producers is going through the Third Wave of the global debt-deleveraging cycle. The first wave – the global financial crisis – started when dropping asset values lead to an evaporation of equity capital in the highly leveraged banking sector. During the second wave – the Eurozone debt crisis – the peripheral countries saw their deficits and debt ratios balloon while market access deteriorated, forcing sovereigns to dramatically tighten fiscal policy. Now, we are in the midst of the third wave, a debt-deflation spiral which is spreading amongst emerging market and commodity producing corporates where indebtedness has risen significantly over the past years. Given a reduction in asset prices – amid weaker growth and lower commodity prices – and higher debt values for those corporates with US-Dollar denominated debt, an increasing number of corporates is being forced to deleverage. In general the period of strong growth across emerging markets, rising commodity prices, strong capital inflows into EMs, the build-up of large FX reserves and a weak US-Dollar were all interconnected but have gone into reverse over the past two years. Now we have weak EM growth, sideways to falling commodity prices, capital flowing out of EM and commodity producers back into Europe and the US, a strong US-Dollar as well as a draw-down of FX reserves. (Further details here: The Third Wave: Debt-deflation spiral reaches the corporate sector)

4.) The economic backdrop will likely worsen further in a number of EM and commodity producing countries. However, China as the most important emerging market should not suffer from a hard landing. While Chinese growth finds itself on a structural downward trend, cyclically growth should be able to stabilise at lower levels amid the support provided by ongoing macro-economic easing steps, from both the fiscal and the monetary policy side.

5.) The outlook for Europe and the US is a favourable one:

• Improved structural situation. Macro-economic imbalances have been reduced, especially in the Eurozone periphery, bank balance sheets have been significantly improved and structural budget deficits have been reduced materially.
  US & Eurozone current account and budget balances
  
  Source: Bloomberg
  
  
• Growth friendly macro-economic policies: Despite the likely start of the rate hiking cycle in the US around the turn of the year and later on in the UK, monetary policy will stay accommodative. In the Eurozone, monetary policy will become even more accommodative amid further ECB action as well as a gradual restoration in the transmission mechanism (i.e. improved credit availability). Fiscal policy will not be restrictive anymore and can become even moderately accommodative (especially in the US and Germany). The Eurozone economy has moved from the blue square in the table below in 2009/10 via the red square in 2011-2013 to the grey one in 2014/15. In 2016 it might just shift into the green area. 
  
  Source: ResearchAhead
  
  
• Rebounding inflation rates: Inflation rates will bottom during autumn and should rise noticeably into late winter amid strong base effects. Thereafter, it can slowly move slightly higher over the medium term. Current inflation rates are around 0% mainly amid the previous collapse in energy prices (as well as the strong USD in case of the US). These effects should weaken in the months ahead. As a result, the Fed’s “Window to wait” and the ECB’s “Window to act” will close early next year unless the economies cool materially. The chart below shows the development of US CPI inflation. In the first scenario, the seasonally adjusted CPI index is left unchanged, meaning that there are zero inflation pressures from now on. In the second scenario, the core CPI index continues to rise by the average rise increase far this year (i.e. core inflation pressures remain unchanged). In the first case, yoy CPI can rise to +1.2% in January, in the latter case even to +1.8%.
  US Inflation developments
  
  Source: Bloomberg, ResearchAhead
  
  
• The strong USD, the subdued growth environment in EMs as well as commodity producers  hurt industrial companies while the low energy prices weigh on the oil & gas sector. On the other side, the recovering housing and labour markets as well as low energy prices support domestic consumers. The discrepancy between the global economy focused/export dependent manufacturing sectors on the one side and the more domestically/consumer oriented services sectors on the other can continue. However, manufacturing and mining account for only 14.5% of US GDP while the private service sectors account for 67.5% of GDP. In the Eurozone, the export environment should in general do ok as the Eurozone and UK economies are mostly dependent on each other as well as the US and depend less on Emerging Markets.
• The Fed will start hiking rates soon, followed a few months later by the BoE. Rate hiking processes will be gradual and the upward pressure on the currencies should provide for part of the necessary tightening. The ECB on the other side will ease monetary policy somewhat further.

6.) Overall, therefore, the global economy should be growing at a moderate pace. However, given the recent significant downgrading in forecasts, it can surprise positively vs. expectations given developments in Europe and the US. Inflation pressures remain limited due to weak commodity prices and global excess capacity. Still, as described above actual inflation rates in Europe and especially the US will rise back closer towards the central banks’ targets.

7.) The multi-decade bond bull market in Europe and the US has ended. While easy monetary policy should keep bond yields below nominal GDP growth – especially in the Eurozone - improved real growth, moderately higher inflation rates and the start of the US rate hiking cycle should take bond yields higher in the years ahead even though this should be a gradual process. Given the very low yields, sovereign bonds do not provide a large enough cushion against such adverse market movements and negative total returns are likely.

10y German Bund yield vs. Eurozone nominal GDP growth

Source: Bloomberg

The Third Wave: Debt-deflation spiral reaches the corporate sector

Already two years ago I warned about the bursting of the Emerging Markets bubble (see for example Developed markets growth improvementvs. busting EM bubble dated August 23 2013). While in the meantime growth in the Eurozone has improved, the situation has indeed worsened across a large number of emerging markets and commodity producing economies. In fact I now think that important parts of the EM and commodity producing corporates face a new debt-deflation spiral which slows down world trade and has already started to negatively impact the US economy.

From 2007 onwards, the unwinding of real estate bubbles forced the overleveraged banking system into deleveraging mode. The resulting adverse and self-reinforcing feedback loop (lower asset prices - weaker banking sector balance sheets - more restrictive credit environment & selling of assets - weaker economy & lower asset prices) threatened the global financial system. This systemic crisis could only be overcome with the help of central banks providing an unprecedented amount of liquidity support and massive fiscal easing programmes. In addition, important financial institutions had to be bailed-out and bad assets were transferred onto the sovereign balance sheet. In order to render the banking system less vulnerable, Over the past years, banks had to secure additional capital and reduce the size of their balance-sheets, thereby lowering their leverage ratios. Due to the massive support programmes the fiscal positions of a large number of developed market sovereigns deteriorated markedly as debt-GDP ratios and budget deficits soared. In turn, debt-dynamics worsened materially and from 2011 onwards, the Eurozone peripheral countries suffered a sovereign debt crisis. 

During this second wave of the global debt-deflation spiral, yields on peripheral debt skyrocketed and the peripheral sovereigns lost market access. Sovereigns were forced to implement drastic fiscal tightening measures which, however, forced their economies into recessions, thereby aggravating the debt crisis. Only with the help of the Eurozone core sovereigns fiscal capacity (via the EFSM/ESM) and the ECB (initially via the SMP and then more importantly the OMT and lately QE) this negative feedback loop could be broken. While debt-GDP ratios remain at very high levels, deficits have been reduced materially in the meantime and with the help of record low yields projected debt dynamics have been improving materially. 

The banking sectors in the US and Europe have been gradually emerging from the financial crisis and leverage ratios have been reduced significantly. Lately also the peripheral Eurozone countries have seen growth rising back into positive territory while the fiscal positions have improved. Now, however, a new third wave of the global debt-deflation spiral is gathering strength , this time in the corporate sector – mainly but not exclusively in the commodities and emerging markets (EM) space. During the past decade, EMs have grown strongly and as these economies exhibit a high commodity intensity of growth, the demand for commodities increased markedly. Coupled with low growth in commodity supply, this lead to the commodities super-cycle. Moreover, just as the global economy emerged from the financial crisis from 2009 onwards, capital flows into EMs and commodity producing economies skyrocketed. On the one side, these countries had healthy fundamentals and a favourable structural growth story. On the other side, investors in Europe and the US wanted to leave their home countries amid the dire state of their economies while the ever increasing supply of central bank money via liquidity provisions and QE put downward pressure on the currencies. In turn, the annual capital inflow into emerging market economies increased from USD 500bn per year in the 2000-2007 period to USD1.100bn in the 2010-2013 period according to the World Bank. Furthermore, the cumulative issuance of external bonds increased from USD 520bn in the eight years up to the financial crisis to USD 1490bn in 2010-2013. Finally, most of the growth in external issuance occurred not from the sovereign sector but from the EM corporate sector. Asia – in particular China - and Latin America were at the forefront of this process as the chart below shows. In addition, the commodity and construction sectors were responsible for the bulk of increased issuance activity. 

As a result, corporate debt relative to GDP increased to approx. 75% across the EM world by 2014 according to the IMF. However, at the same time the growth backdrop has deteriorated markedly starting around 2013 given the build up in (private sector) indebtedness, a loss of competitiveness, rising current account deficits/falling surpluses and growing political risks in a number of countries. Furthermore, the Chinese economic growth is trending lower on a structural basis amid lower productivity growth, worsening demographics and as the economy shifts from manufacturing to services. As a result, the supply-demand balance for most commodities has shifted fundamentally as past investments lead to increasing supply while the muted economic dynamic dampens demand growth. On the other side, systemic risks in the Eurozone have receded while real growth in Europe and the US has been slowly rising. Moreover, as QE in the US has ended and with the Fed moving closer to rate hikes, the US-Dollar has started to appreciate considerably. In turn, capital has been flowing back into the US and Europe and out of EMs and commodity producing economies, putting downward prices on their exchange rates and asset markets. This, however, results in another increase in corporate sector balance sheet leverage as shown by the left-hand chart below. Moreover, as foreign currency debts – largely in USD – have become more popular, the rising USD increases the value of debt while revenues are under pressure given low commodity prices and weaker growth. Hence, there is a new negative feedback loop in progress as a drop in revenues/profitability coupled with high leverage ratios will see an ever increasing share of revenues being devoted to debt service. Pressure mounts to cut costs or dispose of assets which, however, weighs further on economic growth and asset prices. Rising corporate bond yields are only aggravating this process and an increasing number of corporates risks losing bond markets access if this debt-deflation spiral worsens. 

Corporate leverage and debt ratios have been rising markedly

 Source: IMF

This is a corporate sector crises in a growing number of countries and also increasingly affects some corporate sectors in Europe and the US (for example basic resources & materials, machinery & equipment etc.). Given that in comparison to the banking sector corporates exhibit lower leverage ratios and usually have longer maturity bonds outstanding rather than vast amounts of very short term paper, this debt-deflation process should be of a slower nature than the first two waves. In addition, the sovereigns of most affected economies are not overly indebted and several have significant fx reserves which they can use to support the domestic currency or to bail-out parts of the corporate sector. Nonetheless, growth across EMs and commodity producing countries promises to slow down even further/remain at low levels for some time. This should weigh on global growth as well as trade flows and keep disinflationary pressures alive. 

As time progresses, the damage to the European and US economies should become more noticeable. US growth will likely moderate somewhat to around 2%. While the & gas sector is suffering from the collapse in energy prices and the internationally focused large corporates remain burdened by the strong USD, the more domestically oriented smaller corporates as well as the services sectors are doing ok. This is also being mirrored by the discrepancy between the ISM manufacturing and the non-manufacturing indices (see left-hand chart below). Industrial production growth has already slowed down markedly to only 0.9% yoy in august. However, growth in real personal consumption expenditures (which account for roughly 70% of GDP) remains above 3% yoy and is supported by the combination of a robust housing market, ongoing albeit weakening employment gains as well as the collapse in energy prices which restores households’ purchasing power. 

US (left) and Eurozone (right) service vs. manufacturing PMIs

 Source: Bloomberg

 

For Europe, the export environment will likely deteriorate as well over the quarters ahead. However, export shares of Eurozone countries going to the US and the rest of other Western Europe (ex. Norway) are about 2.5times as high as the export shares going to all emerging markets. Hence, the European economies depend mostly on each other and the US. As these countries remain in moderate growth mode, the export slowdown should not be dramatic. More importantly, the combination of easing negative growth effects of fiscal tightening efforts, record low interest rates – with finally also an accommodative monetary policy environment in the peripheral countries – the collapse in energy prices and the restoration of internal competitiveness in parts of the periphery should continue to support the economy. Similar to the US, though, the gap between services and manufacturing PMIs promises to become even more pronounced. Hence, while global growth is subdued and likely to moderate further, the domestic oriented parts of the European and US economies US should do ok, thereby preventing a sharper slowdown. Inflation, though, promises to be very low for longer with inflation expectations likely to drop further as upward pressure on currencies and downward pressure on commodities persist. 

The US Fed remains focused on starting a very gradual rate hiking process as the domestic economy remains in growth mode while they regard current low inflation rates as transitory. For the corporate debt-deflation spiral, however, such higher US policy rates are part of the problem as they threaten to propel the USD and corporate bond yields to even higher levels. The ECB on its part will likely adjust its QE programme amid very low inflation expectations via extending the minimum buying period beyond September 2016. 

 Credit risk is being repriced into corporates just as sovereigns have regained the safe-haven status

 Source: Bloomberg

 

A renewed fundamental shift in the supply-demand balance for commodities, a large dose of fiscal easing in China or a new round of US Dollar liquidity creation (aka QE4) would likely be able to break or at least significantly ease this debt-deflation spiral. For the time being, though, the situation for those corporates located in or being strongly dependent on emerging markets or commodity producing countries will probably become even more challenging. As a result, a cautious stance towards global corporate risk remains warranted. Sovereign debt should still be favoured over corporate debt and the sovereign bond outperformance has likely not yet ended. Within developed markets, domestic, services and household goods oriented as well as smaller corporates should be favoured over export dependent and manufacturing oriented as well as larger and highly indebted corporates. In general, it seems too early to move back into emerging markets and into commodities with the notable exception of precious metals where strategic longs can slowly be opened.  

Phase II of the global bond bear market has started

Following the sharp rise in yields between mid-April to mid-May, 10y Bund yields have fallen moderately back to around 50bp. This movement lower was probably caused by the previous technically oversold condition for bond prices coupled with the ongoing uncertainty relating to Greece, weakish US data as well as doubts with respect to the inflation outlook for the Eurozone as evidenced by the sharp drop in Eurozone inflation expectations over recent weeks.  However, this should only be regarded as a consolidation/correction within a multi-year bond bear market which started this spring (and at the end of January in the case of US Treasuries and Gilts). With signs of an improving US fundamental backdrop becoming stronger, Eurozone inflation surprising to the upside and some movement in the Greek negotiations, global bond yields have just started on their next leg higher.

First, US growth should improve again. US economic data has surprised negatively in recent months due to several factors. The harsh winter weather has held back the economy temporarily while the US West Coast port strike distorted the supply chain. Both factors, however, are of temporary nature only and should have started to reverse already. In addition, given that the US economy is a very large oil & gas producer and given that the fracking technology allows for an almost instantaneous adaption to changing market circumstances, the negative effects of lower oil prices on the oil & gas sector have for the past few months exerted a downward pressure on growth. The growth positive effects of lower oil prices – via increased purchasing power for households and reduced price pressures for energy-consuming corporates – usually take much longer to develop and should only start to become visible. Finally, seasonal adjustments continue to play havoc with US economic data releases. For example the San Francisco Fed estimated in a recent working paper that the residual seasonality of the US economy during Q1 amounts to 1.6% this year (i.e. growth in Q1 has been underestimated by this amount). The chart below highlights that this problem has grown larger over recent decades. 

Average quarterly US GDP growth 

Source: San Francisco Federal Reserve

This problem of seasonal adjustments is also clearly visible in the US ISM index which surprised positively yesterday. The chart below compares the seasonal adjustment factors applied to the raw data in 2007 with those applied this year. As can be seen, April saw a significant upward revision of seasonal adjustment factors, resulting in lower levels of the adjusted data. However, from May onwards this reverses and in June (as well as in September) the seasonal factors are below those applied in 2007. This is all the more remarkable as seasonality should have dropped in the US economy over the past 8 years and not grown. The highly seasonal construction sector as well as the manufacturing sector have become smaller relative to GDP while the less seasonal service sectors such as education and healthcare have grown in importance. Be it as is, the May ISM report out yesterday which showed an improvement in the index of 1.8 points now paints a more reliable picture of the underlying state of affairs than in April. Importantly, the new orders component – seen as a leading indicator – has risen for the second month running and now stands at a healthy 55.8. 

US ISM seasonal adjustment factors 2015 vs. 2007

 

Source: DoC  

As a result, the outlook for the US economy remains favourable. The monetary transmission mechanism has been restored, the housing as well as the labour market have been improving and the growth negative effects of the previous fiscal tightening have been absorbed while the level of pent-up demand remains substantial. As such I remain convinced that the US economy has embarked on a self-sustaining upswing and that US economic data will improve substantially in the weeks and months ahead. Therefore, the FOMC remains on course to start hiking rates in September.

Second, Eurozone inflation continues to increase faster than anticipated by the markets as well as by the ECB. I have already previously highlighted that the underlying inflation pressures have been increasing already since May last year. The chart below separates the developments in Eurozone inflation 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 steadily since then. That core inflation stayed at 0.6% until April was almost exclusively due to the reduction in the price effects of changes in consumption taxes. As these inflation reducing effects have come to an end, core inflation has now also started to increase as evidenced today with the preliminary release of +0.95 for May.

Eurozone HICP and its components

Source: Eurostat, ResearchAhead

Inflation should continue to rise into 2016, be it on the core as well as the headline measure. Moreover, the Eurozone growth outlook continues to improve and growth should rise further 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. Furthermore, amid the time lags involved, the positive impetus will get ever stronger in the months and quarters ahead.

For bond markets, the structural bond bull market of recent years has ended. Over the long-term, developments in sovereign yields and nominal GDP growth are closely linked. This can be seen in the chart below showing the history of US nominal GDP growth and 10y UST yields for the past 55 years. The long-term bond bull-market since the early 80s was fuelled by several components: a drop in long-run trend growth, a structural reduction in inflation rates as well as an evaporation of term premia embedded in longer-term bonds with the latter mostly at play in recent years due to the central banks’ bond buying programmes.  

Long-run 10y UST yields vs. US nominal GDP growth

 Source: St. Louis Federal Reserve

Also in the Eurozone, nominal growth and 10y Bund yields are moving in sync over the longer run. However, while the fall in bond yields until last year was mirrored by fundamental developments (lower inflation and lower growth), the discrepancy between the level and direction of yields – with 10y Bunds falling to almost 0% - and the level as well as direction of growth – with growth having improved to 2% in 2014 from the record low 0,8% in 2013 – has become substantial. Also here this discrepancy should largely stem from the speculation on and subsequent decision by the ECB to engage in a large scale asset purchase programme. 

10y Bund yields vs. Eurozone nominal GDP growth

Source: Bloomberg

As a result, we are in a state where cyclical nominal growth improves – due to both higher real growth as well as higher inflation rates – while risk premia are extremely low due to the central bank purchases. This results in an extremely challenging environment for bond markets. As nominal growth improves, the support provided by central bank for bond markets decreases over the medium term. The FOMC should be the first to hike rates, however, also the ECB’s QE days are numbered. While purchases will last until September 2016, they should be reduced and potentially even terminated before the end of next year. Moreover, the ECB will likely increase the depo rate to 0% during 2016 as it ends the emergency state of negative policy rates.  As a result, we have entered a new cyclical bond bear market – due to cyclically higher growth and inflation. Moreover, while trend growth rates should stay depressed and long-run inflation should not deviate much from the central banks’ stated targets of around 2%, the reduced central bank support should lead to a repricing of term premia over the next years. 

10y UST yield takes another attempt at breaking above their long-run downward trend

Source: Bloomberg

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.