Volatile Rates: A Sign of Normalization or Danger?

Early in the year, the bull market in global bond markets was unstoppable, as oil fell and central banks cut policy rates or added to unconventional easing. But, in Q2, sharp sell-offs reversed many of those gains.

Heatmap: Roubini’s End-2016 Inflation Forecasts (%)

Source: Roubini Global Economics

Market Rather Than Macro Drivers
Until recently, the fall in global yields had persisted fairly steadily since last fall, coinciding with the more downbeat growth outlook the IMF presented at its annual meeting.
In January, the U.S. 10y yield had fallen by 100 basis points as 10y UK and bund yields declined by 130 basis points from a year earlier. That reversed early this year for the U.S., the UK and Japan as growth prospects began to improve.
Bunds were an exception, continuing to decline even as the eurozone’s GDP growth prospects gained further and the high hopes for the U.S. and Japan reversed, spilling over into the other G4 bond markets in March.

Higher Yields Reflect QE’s Success
Bund-yield suppression was likely due in part to the start of the ECB’s QE, as it was:

1. larger than many expected;
2. linked to the Bank’s capital key (rather than to driving down yields in the eurozone’s weakest economies), thus making Germany the largest beneficiary;
3. designed to allow the ECB to buy bonds across the entire yield curve.

With Germany running a fiscal surplus that would cut bunds outstanding by some €8 billion, yet holding just over 25% of the ECB’s capital, there was an additional €10 billion in relatively price-insensitive demand for bunds.
In Greece, meanwhile, the rising risk of a Syriza-led government began pushing up Greek credit-default swaps in December and creating safe-haven demand for bunds. These factors led to large long bunds and short euro trades.
The April bunds sell-off, and spill-over to the rest of the G4, was, we believe, a healthy realignment to economic reality and market conditions, and could be seen as a sign of QE’s success, as it in part reflects higher inflation expectations. However, it was a painful blow to holders of bunds, with the 10y yield rising by 70 basis points.

Sell-Off’s Causes Are Hard to Pin Down
Events that may have shifted prospective demand for bunds in April include optimism about negotiations toward a new Greek adjustment program, and comments on April 21 by German Finance Minister Wolfgang Schäuble on regulatory constraints.
However, as is common in frothy, overbought and illiquid markets, there were no economic surprises to justify the speed and magnitude of the bund-yield spike. We expect German yields to remain compressed, but the start of policynormalization cycles in the U.S. and UK should support a slight increase in long-term yields in those countries. Japanese government bond (JGB) yields will continue to be compressed by extra doses of easing in Japan.

Low Volatility With Bouts of Panic
Looking forward, a tug-of-war between reflationary efforts, disinflationary fundamentals in an environment of crowded trades and decreased market-making means bond markets, while still a “risk-free” benchmark, will be anything but stable.
Central banks in the U.S. and UK need to strike a balance between currency strength and disinflationary forces, and better growth and employment that auger inflation. An end to “zero interest rate policy” (ZIRP) is not only priced into forwards, but volatility is no longer at the suppressed, pre-“taper tantrum” levels, and thus the beginning of rate hikes, while undoubtedly important, should not be destabilizing.
However, further down the line, it’s far from clear what the G4 central banks will do (if anything) to adjust the size of their balance sheets. The Bank of Japan’s and ECB’s work is not yet done, but they have yet to signal what actions will come next.

Risks Around Our View on Rates
There are significant upside and downside risks around our rates expectations.

German Bunds
Bund yields will continue to be subject to forces pushing them in both directions. The presence of a large, price-insensitive buyer in the market (the ECB), the still-low inflation, “safehaven” moves stemming from geopolitical events (including the possibility of “Grexit”—Greece leaving the eurozone) and the absence of new net issuance of German bunds all exert downward pressure on yields.
So, too, would the occurrence of some kind of “accident” in the Greek negotiations, which might force Greece to introduce prolonged bank closures and then capital controls, making it harder to achieve a deal on the next (third) bailout program.
Or indeed renewed weakness in the eurozone economy, originating either in the core or in the periphery (perhaps due to excessive austerity). Or concerns about the financial stability of institutions (such as insurance companies) that are most affected by low long-term yields.
Meanwhile, the prospect of a reflationary move, the effects of higher Treasury yields due to the Fed’s coming hiking cycle, the perceived partial mutualization of eurozone debt via the ECB’s QE and the prospect of more rapid policy “normalization” all exert upward pressure on the 10y bund yield.
And there are other factors that could push it toward the upper end of the 0-1% range in which we see it trading (on average) for the next few years, such as higher realized and expected inflation (for example, as a result of higher oil prices), a stronger-than-anticipated recovery due to the lower euro and rates or a more hawkish-than-expected Fed.

U.S. Treasurys
In the U.S., Treasury yields have been pushed higher by the rise in oil prices and the rise in bund yields. The upside risk to Treasury yields is a further significant rise in either oil or bund yields. That would mostly be a reflection of market dynamics rather than a fundamental change to the U.S. outlook. The downside risk to our Treasury yield call arises from the domestic outlook. Given most estimates of GDP growth are still too optimistic, market realization that the U.S. will miss those estimates could push the yield below our 2.5% forecast.

UK Gilts
We think UK gilts will continue to follow U.S. Treasurys along a lower trend line as the Bank of England will likely wait for the Fed to make the first move. At the same time, if the uncertainty around the UK’s forthcoming EU “in/out” referendum were to weigh on business investment more than we anticipate, UK growth could slow further, which would support a new widening of the long-dated U.S. Treasury-UK gilt yield spread.
And if wage growth were to pick up more significantly than we anticipate, supporting an increase in unit labor costs, the Bank of England might want to step up its policy-rate normalization, which would tend to lead to a closing of the spread.

Japanese Government Bonds
Japanese yields will likely remain dependent on Bank of Japan action and inflation developments. If inflation disappoints again, forcing the Bank to significantly step up its easing program, the 10y JGB yield might fall back toward 0.2%.
Conversely, if inflation surprises to the upside, the 10y yield might rise above 0.5% by year-end.

ETF Securities Research and Roubini Global Economics