No smoke without fire
There is a strange rhetoric surrounding the recent sell-off in European bonds, which pushed yields up for the first time in many months. A number of commentators have admitted that it is difficult to identify the reasons behind it. Perhaps, this time it reflects improving sentiment on the European economy: investors may be shifting assets from low-yielding sovereign debt into riskier securities, as their confidence in a recovery strengthens.
It could be that investors see QE as an opportunity to begin the rotation out of bonds as those investments start to look increasingly unattractive. Alternatively, investors may believe dovish monetary policy will come to an end as inflation forecasts are revised upwards.
In other words, there are many reasons to believe that European (and US) sovereign yields will stabilise in an orderly manner. But there could be another cause for the recent sell-off. Investors may be realising that fixed income markets, particularly sovereign debt, are grossly overpriced, and that it is time to get out before everyone else does – because missing the chance to exit at the right time might lead to disaster.
The indecisiveness regarding the reasons for the sell-off does not bode well. Remember when the S&P500 hit its peaks in 2007? Those peaks were preceded by sharp, sudden drops that were, to a large extent, inexplicable at the time. Then the truth about the health of the financial system started to emerge. Although transparency has improved over recent years, asset price movements are still partly driven by information asymmetries, and a few investors might know something no one else does at this point (shadow banking anyone?).
There are other interesting facts that make the picture even more complex. A recent survey found that global insurance CIOs perceive illiquid fixed income assets, including mortgage securities and infrastructure debt, as overpriced. That would suggest fixed income alternatives to sovereign debt and credit are relatively scarce. According to the same survey, CIOs see fewer investment opportunities overall.
On the other hand, European corporate CFOs are increasingly optimistic about the prospects for their firms. Margins are expected to rise, which would suggest improving economic fundamentals, and lead investors to reconsider their fixed income allocation relative to their overall portfolio. However, CFOs say cost-cutting remains a strategic target and sustained risk-aversion means corporations are still reluctant to invest. The implication of a lack of investment is that the European recovery might be unsustainable.
We will soon find out. Meanwhile, I suspect pension fund CIOs will be scratching their heads – where does one shift money to, when the ‘sell’ alert for sovereign debt activates?