A European head fake
Should investors be worried by a German bond market sell-off that has seen 10-year bund yields rise some 30bp over the last month? The last time European yields climbed this quickly, in early 2015, eurozone stocks swooned in the following year, with the benchmark index falling -27% peakto-trough. Moreover, unlike the US which has seen a long expansion, it is not clear that a still weak eurozone can handle a rise in the cost of money.
It should, of course, be recognised that there are good reasons for German yields to rise. After the Brexit referendum, worst case scenarios for the UK—a key trading partner for big eurozone economies—have yet to materialise. While eurozone growth in 3Q16 came in unchanged at 0.3% QoQ, the latest PMI readings point to a stronger fourth quarter. There are even incipient indications of a pick-up in export demand from Asia. Together with rising inflation expectations due to oil price base effects, bond investors want to be compensated, which is not unreasonable since eurozone bond markets had become just about the world’s most overvalued.
Still, there remains a suspicion that this is not the full story. It does not factor in the sharp fall in sterling which must slow UK imports over the coming quarters. Second, political risks still loom large with the Italian referendum just five weeks away and polls moving against the government’s position.
In truth the key trigger for rising eurozone bond yields has been the lack of clarity over European Central Bank policy. The sell-off started right after the ECB’s September meeting when Mario Draghi declined to signal an extension of its quantitative easing program beyond its March 2017 expiry. The flight to safety amid jitters over Deutsche Bank’s solvency in mid-September provided a brief respite, but by early October yields were again rising on news reports of a looming ECB bond purchase taper.
A taper, however, is unlikely to materialize anytime soon and QE is almost guaranteed to be extended for one more period. One key reason is the fact that credit growth remains extremely sluggish. The latest bank lending data showed that the eurozone credit impulse—the change in credit flows to the non-financial private sector as a share of GDP—has weakened and is now trending downward. The credit impulse matters because it has previously led domestic demand growth, the main driver of the eurozone recovery. With a few exceptions, lending to the private sector remains weak, giving credence to the view that ECB policies are in fact crimping banks’ capacity to lend. That may be the case, but it seems likely from Draghi’s recent comments that the ECB still sees the medicine as having beneficial effects, so the most likely course of action is a double-down on the policy. From a recent speech by ECB Board member Benoit Coeure it is clear that the ECB sees QE and negative interest rates as the right policy mix to address real equilibrium rates which are at or below zero and a structural growth rate that continues to decline.
If this argument is right, the question is why the ECB engaged in such a tease with the markets by not revealing its new plan until its December 8 meeting. After all, the ECB has confirmed that it is running out of eligible German bunds it can buy and so must refine its program. There are several ways it can do this: one would be to break from the “capital key” ratio and buy more liquid bonds, a policy that would boost its purchases of Italian bonds. It seems likely that the reason the ECB delayed such a decision is that it wanted to wait until after Italy’s constitutional referendum on December 4. The last thing the ECB would want to have done is promise a cap to Italian bond yields just ahead of the country potentially being engulfed in political chaos, should Prime Minister Matteo Renzi lose the vote and thereafter call a general election, which has the potential to be fought on the issue of the country’s continued participation in the single currency. Such a situation would have left it vulnerable to German criticism that the ECB was doubling down on increasingly risky Italian debt.
For now rising bond yields and a steeper curve are offering a respite to European banks and have expanded the pool of eligible bonds that the central bank can purchase in its QE program. Still, looking at the direction of the economy and likely policy responses this seems likely to be a short term correction before the ECB re-asserts itself— one way or another—after the Italian referendum.