At the recent market peak, in late April, holders of 30-year German bunds were enjoying year-to-date returns of 23%. The dramatic reversal since then has entirely wiped out these gains: this is hardly the sort of behaviour one would expect from Europe’s premier ‘risk-free’ asset.
In our view, this phenomenon was caused by a crowd-surge into eurozone deflation/ quantitative easing (QE) trades and then a ‘rush for the exit’, when investors realised just how overpopulated and overvalued these trades had become. Overshooting markets do not always need a fundamental trigger to spark a reversal, but the rise in eurozone inflation in May, when core CPI rebounded to a 1-year high, certainly added some urgency to the unwind.
Morality check
We wonder whether today’s bund investors could learn some lessons from the Japanese government bond (JGB) market of the early 2000s. Having trended lower for more than a decade, 10-year JGBs troughed at 0.4% in June 2003. Even though Japan endured a grim eight-year decline in gross domestic product from that point, anyone who bought JGBs at the yield low in 2003 made just 1% per annum over those eight years and was in loss for the first four years of the trade. The moral of the story is: once economic stagnation is priced in, bond returns can be low and volatile, even if the economy continues to disappoint.
Furthermore, when we look at the eurozone today, we see an economy that is recovering, not stagnating. Consensus forecasts for 2015 growth have been rising for six months and inflation forecasts have been rising since February. Looking ahead, we expect more of the same as the impact of euro weakness, lower oil prices, easier credit conditions, and diminishing fiscal austerity kick in. Even though European Central Bank QE will continue to exert downward pressure on eurozone bond yields well into 2016, economic recovery is now emerging as a force that will act in the opposite direction.
Growing pains
Although bunds have seen the biggest swings this year, all the major government bond markets have followed the same pattern, with Q2 shaping up to be the worst quarter for sovereign bonds in almost 30 years. As is the case with eurozone bonds, the recent sell-off began as an unwinding of Q1’s euphoria, but more recently, has begun to reflect improving economic data, particularly in the US.
Peer pressure
Following a disappointing start to 2015, US data have significantly improved over the last few weeks. A number of key series – retail sales, payrolls, job openings, consumer confidence, and homebuilder surveys – have surprised to the upside, suggesting the economy is regaining momentum and pulling away from Q1’s soft patch. We think this trend will continue in coming months, prompting the US Federal Reserve to raise interest rates before the year is through and keeping upwards pressure on US bond yields.
We see the recent sell-off in government bonds as largely correcting Q1’s overshoot. If our base case scenario of continued global recovery is realised, we do not expect to see Q1’s yield lows again during this cycle and think yields will grind higher in H2. Higher yields will not necessarily undermine risk assets if they reflect improving economic conditions. However, investors would do well to take note of Mario Draghi’s recent comment: “Get used to periods of higher volatility”.
Paul O’Connor is Co-Head of Multi Asset within the Henderson Multi-Asset team.