Download In Brief Global bonds: one mighty sell-off, numerous causes

Global bonds: one mighty
sell-off, numerous causes
Pictet Asset Management Strategy Unit I For professional investors only
In Brief
May 2015
Global government bond markets have recently witnessed one
of their biggest four-week declines on record, and investors
are struggling to identify the cause. In our view, there is no
single trigger. Rather, a number of fundamental and technical
developments have conspired to push yields higher.
At the beginning of 2014, strategists and analysts were keen to tell anyone who
would listen to sell government bonds. Valuations, they argued, were simply
too high at a time when the US Federal Reserve was preparing to raise interest
rates. Bonds could only go down. How wrong they were. By the end of that year,
yields on developed market sovereign debt were even lower, with the JP Morgan
global government bond index delivering an annual return of 8.5 per cent (in local
currency terms). The trigger for the rally was as easy to spot as it was impossible
to foresee: a precipitous slide in oil prices.
• The bond market’s recent
plunge can be blamed on a
combination of technical and
fundamental factors
• Investors likely balked at the
eye-watering valuations in
the euro zone, but unfavourable changes in government
bond supply also had a part
to play
• The euro zone’s recovery and
higher inflation expectations
contributed to the sell-off too
Fast forward five months, however, and the bond bears have found their voice
once more. Global government debt has seen its steepest four-week slide on
record, plunging 2.5 per cent since mid-April.1 But in contrast to the rally of 2014,
there is no single factor responsible for the market’s violent change in direction.
There are many different triggers for this one big shift.
What is behind the sell-off?
1. Extreme valuations
Thanks to central banks’ increasingly aggressive financial repression - the
deliberate driving down of interest rates to levels below inflation – negative
nominal bond yields have become a feature of the investment landscape. In the
weeks following the implementation of quantitative easing from the European
Central Bank, about 16 per cent of the bonds in JP Morgan’s government bond
index, some USD3.6 trillion, and one in four euro zone sovereign bonds were
offering negative nominal yields. Viewing recent developments through a
different lens, the valuation of the euro zone bond market appears even more
extreme. At one point, the 10-year German Bund was trading at a real yield of
-1.32 per cent. That is almost 40 basis points lower than trough hit by the 10-year
US real yield in October 2012. At a time when the euro zone economy appears to
be gathering strength, such exceptionally low yields look difficult to justify.
1
Decline in local currency terms; data covering period 14.04.2015-14.05-2016
2 | GLOBAL BONDS: ONE MIGHTY SELL-OFF, NUMEROUS CAUSES | MAY 2015
2. A (temporary) shift in ECB bond buying, sovereign
debt issuance
Although the combination of QE and a decline in government
borrowing in the euro zone can – all things being equal - be
expected to bear down on sovereign debt yields, the month
of May witnessed an unfavourable (possibly temporary)
shift in bond supply and demand dynamics. Not only was
net issuance of government bond debt positive to the tune
of some EUR45 billion2, but the ECB also switched from
buying higher-duration securities to lower duration ones.
These developments conspired to amplify the sell-off in
longer-dated euro zone government debt.
FIG. 2 – EXPECTATIONS FOR INFLATION HEAD HIGHER
Change in 5y5y inflation swap rate since trough, percentage points to
0.60% —
0.50% —
0.40% —
0.30% —
0.20% —
0.10% —
0.00% —
FIG. 1 – NET DEBT ISSUANCE IN EURO ZONE SPIKED IN MAY VS APRIL
Net government bond issuance in euro zone, EUR billion (issued/projected)
EU
UK
Source: Thomson Reuters Datastream; trough hit on 14.01.2015 for EUR, 16.03.2015
for US and 19.03.2015 for UK; period end 10.05.2015
100 —
4. A brighter outlook for the euro zone
50 —
0—
-50 —
-100 —
US
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Economic conditions are improving across the euro zone.
The most positive signal comes in the shape of increased
bank lending to both households and companies – a trend
that had begun to emerge months before the ECB decided
to embark on quantitative easing. The supply of credit had
been contracting a monthly rate of 0.8 per cent in May 2014
but has been rising ever since. It is now firmly in positive
territory.
Source: ECB, Pictet Asset Management
FIG. 3 – CREDIT CONDITIONS IMPROVING IN THE EURO ZONE
With oil prices rebounding, worries that the world would
succumb to a deflationary spiral have all but evaporated.
The 5y5y EUR inflation swap rate – the market’s expectation
of where inflation will be in approximately 10 years’ time –
has risen to about 1.8 per cent, not far from the ECB’s target
of near or at 2 per cent.
Supply of credit, month-on-month rise, %
1.5 —
1.0 —
There are also tentative signs of a build-up in inflationary
pressures in the real economy.
0.5 —
Core inflation worldwide troughed some months ago and
has been picking gradually ever since. US wages are also
beginning to rise – the latest data shows an increase of
some 2.6 per cent per year. What is more, the gauges we
monitor suggest inflationary pressures should continue to
build steadily over the course of the year. The resource
utilisation rate across the world’s major economies – our
own proxy for a country’s operating capacity – indicate
that economic activity is building to levels that will begin to
fuel inflation. Tellingly, the last time the US utilisation rate
was at its current level was in 2004, when the US Federal
Reserve last embarked on a policy of monetary tightening.
0.0 —
-0.5 —
-1.0 —
03
. 20
13
. 20
13
07
. 20
13
09
. 20
13
11
. 20
13
01
. 20
14
03
. 20
14
05
. 20
14
07
. 20
14
09
. 20
14
11
. 20
14
01
. 20
15
03
. 20
15
-1.5 —
05
3. Fears of deflation evaporate
Source: ECB, Pictet Asset Management
2
Net issuance is total sovereign bond issuance minus ECB debt purchases
GLOBAL BONDS: ONE MIGHTY SELL-OFF, NUMEROUS CAUSES | MAY 2015 | 3
5. An impaired secondary bond market
As regulatory oversight of the banking sector has
intensified, banks have scaled their fixed income marketmaking activities.
This appears to be having a negative effect on liquidity:
trading conditions are not as favourable as they were in the
years prior to the credit crisis in 2008, when the market was
much smaller than it is now. The situation has arguably
been made worse by the growth in fixed income assets
held by funds offering investors daily liquidity. Investors
in such vehicles tend to buy and sell at the same time. The
combination of many sellers and a shrinking pool of market
makers can amplify price moves.
Outlook and portfolio positioning – global
government bond portfolios
In our global bond portfolios, we have held an underweight
position in German government bonds for some time
and have instead favoured debt issued by sovereigns in
peripheral Europe. We retain this stance as we believe one
of the goals of the ECB’s QE is to make it easier for countries
such as Spain and Italy to place their long-term finances
on a more stable footing. Over the medium term, the 10year German Bund yield could edge higher – somewhere
between 0.8 and 1 per cent – before settling back lower in
the summer months, when supply and demand dynamics
in the euro zone debt market are set to become more
favourable. Over the near term, it is also increasingly
difficult to make the case for yields to rise further in the
US, particularly if the country’s recovery continues to lose
steam.
Mickael Benhaim, Senior Investment Manager
and Co-Head, global bonds
Luca Paolini, Chief Strategist
Supriya Menon, Multi-Asset Strategist
ABOUT THE PSU
The Pictet Asset Management Strategy Unit (PSU) is the investment
group responsible for providing asset allocation guidance across stocks,
bonds, cash and commodities.
Each month, the PSU sets a broad policy stance based on its
analysis of:
•business cycle: proprietary leading indicators, inflation
•liquidity: monetary policy, credit/money variables
•valuation: equity risk premium, yield gap, multiples vs. history
•sentiment: Pictet sentiment index (investors’ surveys, tactical
indicators)
Pictet Asset Management Limited
Moor House
120 London Wall
London EC2Y 5ET
www.pictetfunds.com
www.pictet.com
This material is for distribution to professional investors only. However, it is not intended for distribution to any person or entity who is a citizen or resident of any locality, state, country or other jurisdiction where such
distribution, publication, or use would be contrary to law or regulation.
Information used in the preparation of this document is based upon sources believed to be reliable, but no representation or warranty is given as to the accuracy or completeness of those sources. Any opinion, estimate
or forecast may be changed at any time without prior warning. Investors should read the prospectus or offering memorandum before investing in any Pictet-managed funds. Tax treatment depends on the individual
circumstances of each investor and may be subject to change in the future. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is
not guaranteed. You may not get back the amount originally invested.
This document has been issued in Switzerland by Pictet Asset Management SA and in the rest of the world by Pictet Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority,
and may not be reproduced or distributed, either in part or in full, without their prior authorisation.
For UK investors, the Pictet and Pictet Total Return umbrellas are domiciled in Luxembourg and are recognised collective investment schemes under section 264 of the Financial Services and Markets Act 2000.
Swiss Pictet funds are only registered for distribution in Switzerland under the Swiss Fund Act; they are categorised in the United Kingdom as unregulated collective investment schemes. The Pictet Group manages
hedge funds, funds of hedge funds and funds of private equity funds which are not registered for public distribution within the European Union and are categorised in the United Kingdom as unregulated collective
investment schemes.
For Australian investors, Pictet Asset Management Limited (ARBN 121 228 957) is exempt from the requirement to hold an Australian financial services licence, under the Corporations Act 2001.
For US investors, Shares sold in the United States or to US Persons will only be sold in private placements to accredited investors pursuant to exemptions from SEC registration under the Section 4(2) and Regulation D
private placement exemptions under the 1933 Act and qualified clients as defined under the 1940 Act. The Shares of the Pictet funds have not been registered under the 1933 Act and may not, except in transactions which
do not violate United States securities laws, be directly or indirectly offered or sold in the United States or to any US Person. The Management Fund Companies of the Pictet Group will not be registered under the 1940 Act.
© Copyright 2015 Pictet - Issued in May 2015.