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.  

A pronounced cyclical Eurozone upswing is in the offing

The structural factors holding back the Eurozone remain substantial, most notably poor demographics, high indebtedness and a lack of reforms in large countries such as France and to a lesser extent Italy. These structural deficiencies are mainly responsible for relatively low trend growth, probably close to around 1.5%. On the other side, cyclical forces are about to provide the strongest aggregate growth support in a long time. As a result, Eurozone growth should increase markedly in the quarters ahead, likely moving to around 2.5% on an annualised basis by year-end.

First, oil prices in Euro have collapsed and are now down by approx. a third since June last year. It is thought that a 10% drop in oil prices reduces the CPI index by approx. 0.2% and might increase GDP by 0.3%. However, the effects on inflation have largely run their course after three months while it takes 3-4 quarters before the effects on growth become visible. Hence, oil prices are only just about to start exerting their growth positive impetus with the support becoming ever stronger as the year progresses.

Second, the Euro has appreciated since the summer of 2012 until reaching a high in between Dec13 and March14 before moving slightly lower during summer and sharply lower from December onwards. Changes in the trade-weighted currency usually take around 6-9 months before they are being reflected in the economy. Hence, so far only the growth negative effects of the previous strong Euro period should have been absorbed. The growth positive effects of the subsequent Euro weakening are just about to begin and should also become stronger as the year progresses.

The collapse of oil prices (in Euro, red) and the fall in the trade-weighted Euro (white) will exert a growth positive effect

Source: Bloomberg

Third, real yields have moved sharply lower. 10y German real yields have already from 2009 started to become growth supportive as they fell from 2% in 2008 to below 1% in 2011 and have traded below 0% for most of the time since 2012. On the other side, peripheral real yields have been at historically high levels during recent years, thereby exerting a growth negative effect on the economy. As an example, 10y BTP real yields increased from approx. 2.5% in 2008 to 7% in late 2011, before starting to fall as the ECB implemented its emergency measures. Still, even at the beginning of last year, 10y Italian real yields hovered around 3%, a substantially restrictive level for a country where trend growth stands around 0.5%. By now, though, real yields have fallen to approx. 0.3% and should thus provide for an increasing growth tailwind. 
 

10y BTP real yields (left) have become growth supportive

Source: Bloomberg 

Fourth, credit creation has been negative ever since the Eurozone sovereign crisis broke out in 2011. The right-hand chart below shows the yoy growth rate of MFI loans to the private sector. Loan growth peaked in 2011 when the Eurozone debt crisis broke out and moved into negative territory. Negative loan growth became even more pronounced during 2013 as banks prepared for the ECB’s comprehensive assessment (as the end 2013 balance sheets were used for the AQR). However, loan growth has bottomed a year ago and has slowly recovered since. The outstanding level of loans has bottomed in August last year, just ahead of the release of the AQR results. In between September 2011 and August 2014, loans were reduced by a total of EUR 670bn, which also constituted a significant drag on the economy. Looking ahead, though, the banking sector has been largely recapitalised and the new single supervisory mechanism (SSM) is now in place. Banks are thus finally in a position to more actively manage their balance sheets while improving growth coupled with lower loan rates – substantially so in the periphery – suggests that loan demand should pick up again. Hence, credit creation promises to move back into positive territory, thereby also turning from a growth headwind to a tailwind. 

Credit creation has bottomed

Source: Bloomberg 

As a result, monetary policy has finally become accommodative for the periphery for the first time since the Eurozone debt crisis broke out in 2011. Moreover, fiscal policy has been a significant drag on growth in recent years amid large scale austerity measures. According to the IMF, the cyclically adjusted primary balance for the Eurozone has moved from a deficit of 2.5% in 2010 to a surplus of 1.2% in 2014. Hence, fiscal policy has accounted for a drag of approx. 4% of GDP or 1% per year in recent years. However, the austerity drive has weakened during recent quarters and fiscal policy has moved from being very restrictive to becoming only mildly so and thus the growth negative impact should be much smaller as well.

On a country basis, Germany should continue to do well amid growing exports and a supportive backdrop for the domestic economy (low real yields, high employment, rising real wages). More importantly, France and Italy promise to move from below trend to above trend growth by the end of next year. The substantially weaker Euro should be of vital importance for these countries exporters given that they mainly compete via price and less via product complexity/quality such as for example Germany. In the case of Italy, the sharp drop in nominal and real yields should also provide for relatively higher support.  

Summing up, monetary policy as well as oil price and exchange rate developments turn from a significant growth negative factor towards a marked growth positive one while the growth negative impetus of fiscal policy abates. Therefore, Eurozone growth should move from a below trend pace to a markedly above trend one of around 2.5% on an annualised basis towards year-end. As growth improves, so should the long-run trajectories for the debt-GDP ratios across the Eurozone. The structural primary balances have mostly moved into surplus already and fiscal deficits should become significantly lower amid higher growth and lower yields. Markets should increasingly focus on these materially improving Eurozone growth prospects.

Swiss policy mistake

The removal of the EURCHF floor by the SNB is a very large policy mistake. Apparently the inflows into the Swiss franc have been too large for the SNB to continue increasing its balance sheet in order to absorb the inflow and keep the floor intact. Moreover, as the ECB will engage in QE next week, the SNB feared that the inflows would even increase further and given the strength of the USD over recent months (which dampens the appreciation of the CHF on a trade-weighted basis) probably thought that it could get out of the minimum exchange rate floor policy relatively easily.
However, what the SNB has done is tighten monetary policy sharply as well as injecting a heavy dose of policy uncertainty into the Swiss economy.
First, inflation has already fallen into negative territory in December amid the fall in oil prices and should have expected to fall further in the short term. Now, however, the SNB has added another sharp deflationary shock for the Swiss economy. In turn, inflation - on the headline and core measures - will fall significantly further. While it has also lowered the 3m Libor target rate as well as the rate charged for deposits held with the SNB from -0.25% to -0.75%, nominal bond yields and mortgage rates are unlikely to fall to the same extent as inflation. Thus, not only has the currency appreciated sharply within a matter of minutes, but also expected real yields have probably risen (unfortunately this is a guess as there are no CHF inflation swaps). While SNB president Jordan stated that the Swiss exporters have had 3.5y of time to adapt to the higher CHF, the new appreciation is very drastic and has never occurred in such a fast period of time. In turn, exporters have just lost 20% in terms of international cost competitiveness overnight, a development which will cause significant pain. Besides exports, also investments should be negatively affected amid the lower exports, the renewed monetary uncertainty as well as the likely higher real yields. In turn, nominal growth - which has already been muted in recent years - will likely turn negative in the quarters ahead.

Trade-weighted Swiss franc shoots to all-time high

 Source: Bloomberg

Moreover, this step is unlikely to end the inflows into the Swiss currency. For one, Switzerland and thus the Swiss franc has likely seen large capital inflows recently not only due to the Euro's renewed weakness but probably even more so due to capital flight out of Russia. Switzerland's safe-haven status, the fact that several Russian oligarchs already operate out of Switzerland and in addition that Switzerland is only half-heartedly following the EU sanctions against Russia should be responsible. The ongoing Ukraine/Russian crisis suggests that these inflows will remain. Moreover, as QE in the Eurozone just gets going, the downward pressure on the Euro will likely remain, not least due to uncertainty with respect to Greek political developments. As a result - and given that the Swiss current account surplus amounts to approx. 10% of GDP - inflows into the Swiss franc and thus appreciation pressure should remain. The negative 0.75% interest rate on SNB deposits is only a weak form to counteract more safe-haven inflows as most of the deposits are not affected anyhow (due to high allowances) and given that 0.75% per year does not seem a lot for those fearing for their wealth. Hence, in order not to see the Swiss franc appreciating much further, the SNB will still be forced to intervene, however, now at lower EURCHF levels and with a much lower institutional credibility. The only alternative to save the Swiss export sector from even more pain might be some kind of capital controls (which would be done by the government). It seems that the SNB did not gain much as it still needs to intervene in large amounts but clearly damaged its credibility and has just forced nominal GDP growth significantly lower.

Macro-prudential policies & the Great Moderation 2.0

Macro-economic volatility has decreased substantially from the mid 80s onwards in a large number of economies. This period of reduced macro volatility was termed the Great Moderation. However, during the financial crisis GDP growth plummeted and inflation evaporated just to rebound thereafter amid massive fiscal and monetary easing. This lead macro volatility higher and stopped the talk of the Great Moderation. However, as of late volatility in a large number of economic data – most notably growth and inflation – has decreased again. This is shown in the chart below for US real GDP growth. There are a number of reasons for a more stable growth development, most notably that modern economies are far less dependent on the very cyclical and volatile manufacturing sectors but more dependent on less cyclical and less correlated services sectors (for example, education and healthcare). Moreover, inventory management has also been a key factor in determining macro-economic volatility. During good times, manufacturers and retailers increase their inventories, thereby leading to even higher growth. During bad times, though, they want to reduce inventories and as a result, production needs to be decreased by more than demand has fallen, aggravating the downturn. Nowadays, however, more manufacturers use just-in-time management methods and are used to lean inventories. As a result, this also reduces macro-economic volatility (and again services are less volatile as services can not be stored and hence there is no inventory problem). Additionally, the state has a larger role within the economy than during previous periods and tends to act as an economic stabiliser. Finally, the monetary policy enviornment has changed as central banks increasingly focused on providing for a stable enviornment via the adoption of inflation targets. As central banks have become more credible in securing a low inflation environment, inflation expectations and therefore also inflation has become more stable (and inflation tends to be more stable at low levels anyhow).  

US GDP and rolling standard deviation: increased stability after the Financial Crisis 

Source: Bloomberg, ResearchAhead

These factors are all still in existence and hence this should be seen as the main reason why the environment of low macro-economic volatility has re-established itself. What is more though, nowadays there is one additional element at play as a means to prevent another financial crisis: the increased usage of macro-prudential policies. The aim of such policies is to manage systemic risks within the banking sector as well as the broader economy. It thereby should lower the probability of another devastating financial crisis. Mostly, it is expected to do this via preventing the build-up of new excesses in certain regions or sectors. As an example, facing a credit-fuelled house price surge, the macro-prudential regulator would for example demand higher capital buffers or reduce the maximum allowed loan-to-value ratio. This should ease rampant credit growth and should thereby stabilise the housing market. 
For overall economic growth it means that it should be somewhat lower than would otherwise be the case. Furthermore, the central bank does not need to take care of regional or sectoral excesses. Combined with a more subdued growth rebound it can refrain from hiking rates for longer. Or put differently, the central bank does not need to raise rates in order to break the neck of a housing boom (and thereby killing the economy) but can instead focus on the overall economic developments. In this case, it should also take longer for inflationary pressures to materialise amid an overall less pronounced growth recovery. On the other side, if a downturn hits, it should also be milder and shorter as the previous excesses were smaller and there are more instruments available (easier capital rules, lending standards) to counteract the downturn than was the case in earlier business cycles. 
As a result, the introduction of macro-prudential policies should help to lower macro-economic volatility further and serves as a partial substitute for traditional monetary policy. This can be seen with the example of Switzerland. The Swiss National Bank introduced a floor in the EURCHF rate in 2011 in order to prevent a strong currency from driving the economy into a deflationary recession. However, doing so meant giving up implementing an independent monetary policy. Effectively, the SNB can not hike rates for as long as the ECB does not hike rates or it needs to give up on its exchange rate target. The resulting loose monetary policy environment (zero rates and aggressive balance sheet lengthening) provided fuel to an already existing housing market upturn. In order to slow down the housing market, the Swiss government has – on the request from the SNB – increased banks' counter-cyclical capital buffers for mortgages for the second time in January this year. This measure should promote a less loose environment in the mortgage market while at the same time allows the SNB to conduct its easy monetary policy for the broader economy for longer. 

For markets, the lower macro-economic volatility should be mirrored in lower financial market volatility across asset classes. Moreover, the volatility of central bank rates should drop even more as in those currency areas where macro-prudential policies play a more important role, policy rates need to be changed by less. This also means that respective central banks can wait longer before they revert to rate hikes.This all argues in favour of carry and of less liquid products across financial markets as well as for an environment of lower risk premia and flatter curves than at similar stages during previous business cycles.

EM slowdown should not threaten European and US recovery

Currencies of non-commodity producing developed economies appreciated significantly over the past twelve months. Moreover, growth has been weakening in a large number of emerging markets. Does this threaten the growth recovery underway in Europe and the US? I do not think so as the upward pressure on EUR, GBP and USD results from capital flowing back into these areas, providing for looser monetary conditions which works against the fx-induced monetary tightening. Moreover, while exports going into EMs and commodity producers should be negatively affected, the European economies are mostly dependent on each other and therefore might find themselves in a mutually reinforcing recovery.

During the past decade, emerging markets have grown strongly and a lot of capital has flown into the emerging markets world. Additionally, as EM have a high commodity intensity of growth, the demand for commodities increased significantly. Coupled with low growth in commodity supply, this lead to the commodities super-cycle. However, higher commodity prices put upward pressure on European (ex Norway) and US inflation and downward pressure on growth. Thereby, it worsened the debt crisis of recent years and lead to more capital flowing out of Europe/the US into EMs and commodity producers. Last year, however, this process went into reverse. The fundamental environment for a large number of Emerging Markets and commodity producing economies has been deteriorating amid the build up in (private sector) indebtedness, loss of competitiveness, rising current account deficits/falling surpluses and growing political risks. The fundamental supply-demand balance for commodities has deteriorated as well amid higher supply growth on the back of the previous rise in investment and lower demand growth due to weaker growth in the commodity intensive emerging markets. On the other side, systemic risks in the Eurozone have receded, real growth in Europe and the US is slowly rising and QE draws to an end, leading to upward pressure on UST, Gilt and to a lesser extent Bund yields.    
 

Developed markets and commodities: From a vicious to a virtuous cycle

  Source: ResearchAhead

In turn, capital has started to flow back out of EMs and commodity producers into Europe and the US, leading to strong upward pressure on currencies such as EUR, GBP and USD. Thereby, the previous vicious cycle has given way to a virtuous cycle. Commodity prices have stopped rising/been dropping. This puts downward pressure on inflation but supports real growth. This in turn, eases the debt crisis and helps to improve fiscal budgets. This process has much further to run and the trends of recent quarters where DM assets outperform vs. EM assets - with EUR, GBP, USD appreciation vs. a broad basket of currencies, EM vs. DM spread widening and DM equity market outperformance – can continue. While the appreciation in EUR, GBP and USD acts to tighten monetary conditions, it also props up asset prices and provides for an improvement in financing conditions – especially in the Eurozone periphery – which constitutes a loosening of monetary conditions. Just as EM equity markets dropped significantly in recent months, DM equity markets moved higher. Furthermore, as the chart below shows, sovereign CDS in Europe and the US fell sharply while sovereign CDS in emerging markets rose significantly. 

12m change in 5-year sovereign CDS

Source: Bloomberg

Moreover, the export environment should improve despite the stronger Euro and a more challenging environment for emerging markets and some commodity producers. The table below shows exports in % of GDP for Eurozone countries. The first row shows exports going to other Eurozone countries, the UK, Switzerland, Sweden, Denmark (i.e. Western Europe ex Norway) and the US. The second row contains exports relative to GDP going to Emerging and Developing countries. The final row shows the ratio of the two numbers. Exports to Western Europe and the US far outweigh those going into the EM world. The Euro did not appreciate much vs. these currencies (it even depreciated slightly vs. CHF and GBP). Only in the case of the USD has it appreciated meaningfully over the past year. However, with a rise of approx. 6% this should not be enough to negate rising demand on the back of higher US growth. In turn, export demand for Eurozone countries (and the UK) should improve given that they are mostly dependent on each other, thereby mutually reinforcing their cyclical upswing!