Bond managers are worryingly sanguine
ECB president Mario Draghi unveiled his latest measures to arrest disinflation and rouse dormant corporate lending markets in June. Soon afterwards, big records started tumbling.
Deutsche Bank scoured its data for France’s 10-year bonds and couldn’t find a lower yield than the 1.65% it hit the day after Draghi’s press conference. That data goes back to 1746, when Louis XV was marching through Brussels. Spain’s benchmark bond yield also made the record books, which go back to 1789.
On a shorter timeframe, but just as interesting, Markit’s iTraxx Europe Senior Financials index of credit default swaps is threatening to trade through its main index for the first time since the early rumbles of the euro-zone thunderstorm. Credit investors are pricing Europe’s banks as if they were any another corporate sector.
This all sounds like great news. The epicentres of the two great financial crises of our times, banks and the weaker members of the euro-zone, are attracting generous flows of capital. But in terms of the ECB’s objectives, it is anything but.
The reason is that it suggests that Draghi’s major initiative – targeted long-term refinancing operations (TLTRO) – may be counterproductive. He has tried to guard against this: ‘targeted’ means that, while the first two-year phase comes free of conditions like the original LTRO, the second two-year phase is only available to banks that cross certain thresholds in lending to European SMEs.
Borrowing at 0.25% for the next four years looks great, as long as it comes without stigma in the Asset Quality Review later this year. But there are plenty of reasons not to lend the money on to SMEs: they are risky, and a distraction from sorting out existing non-performing loans – activity that is necessitated by regulation and approved-of by providers of bank capital. It is not clear why banks wouldn’t take this as an opportunity to book another two years of carry trades from peripheral euro-zone bonds, further deepening the link between lenders and sovereigns, before paying it back. This was good for sentiment when Spain was borrowing at 7%, but is less so at 2.6%.
And the fact that sovereign yields have been pushed to that level at the same time as bank credit spreads have tightened suggests this is precisely what markets expect. As many bond portfolio managers told IPE this month, the combination of bank de-leveraging and corporates reluctant to gear up because they cannot see where growth will come from results in something of a ‘Goldilocks’ outlook for their asset class.
Sure enough, as I write, the Netherlands is reporting frighteningly low year-on-year inflation for May of just 0.1%, a week after the euro-zone as a whole saw its number slip to 0.5%. Bond portfolio managers are worryingly sanguine. But I’m not worried that they may be wrong; I’m worried that they may be right.