In these times of greatly diversified capital markets within Europe and exciting developments in corporate bonds, high yield or credit derivatives, it has become uncommon for the very low yielding government bond markets to be the real focus of investor attention. But as European and US interest rates have started to diverge, government bonds really are back in the limelight.
“Since September, euro-corporates have been essentially neutral versus the government sector, and credit markets have been very quiet,” says Matthieu Louanges of Pimco. “Government bond markets, on the other hand have really been the focus of attention. The customary positive correlation between US Treasuries and European government bonds has turned upside down and we have seen a sell-off in the US and a significant rally in Europe.”
As to the drivers of these diverging bond yields, one of main factors is seen as the contrasting economic fortunes either side of the Atlantic. “We have seen a profound weakening in the ‘soft’ data coming out of Europe,” says Andrew Connell of Barclays Global Investors (BGI). “The GDP growth that the Euro-zone has been enjoying was fuelled by the external side which has not acted as a catalyst for the domestic side so we have not seen job creation or an increase in consumption either.”
Connell continues: “That domestic demand has not picked up is in part due to the restructuring of corporate Europe. There has been a gradual breakdown in union power which, together with the availability of cheap labour from eastern Europe, has meant that employers have been able to ensure that employees forgo increased wages in exchange for increased job security.
“In regard to our investment strategy, we currently differentiate very strongly between the US and the Euro-zone,” states Louanges. “ In the US, lower bond yields are very much more under threat from several factors. Firstly fiscal and monetary policies are very stimulative. Also, what we are seeing in the US is a trend towards re-regulation as opposed to de-regulation. With the terrorist attacks on the World Trade Center and the scandals at ENRON and WorldCom, and the US is becoming much more conservative in terms of its attitudes towards corporate governance, and increased regulation in the conduct of business and international trade. And together with the greatly increased focus on security, it looks like America is closing in on itself,” he says.
“When a country is experiencing trends towards increased regulation and increased government control in all sectors not just finance, historically this has tended to generate an inflationary environment,” says Louanges. “Factoring in significant weakness of the US dollar would tend to exacerbate the situation. We argue that it is a time to be cautious on US bonds and to seek inflation protection.”
Louanges contrasts the situation in Europe where there is de-regulation in the jobs’ markets, the melting of borders, the increasing competition between businesses and the opening up to competition of the previously monopolistic utility sectors. He points out that monetary and fiscal policies are not nearly so expansionary as they are in the US.
“With short term nominal rates at 2%, and inflation around 2%, real yields are essentially neutral, which contrasts with negative short real rates in the US, We would also argue that Euro-zone fiscal policy is not overly stimulative either. Yes, deficits are large and we have seen increases but this is not that same as in the US where they have swung from a huge surplus to huge deficit in a relatively short time,” says Louanges.
“ So in essence, we have two reasons driving the decoupling diverging economic conditions: and soon we could probably have a decoupling in terms of monetary policy,” agrees Eric Brard at SocGen Asset Management. “The Fed will continue raising rates in order to normalise monetary conditions in the US. If there were to be any risks of rising inflation within the European economy, then the risk of seeing the ECB raising rates would undoubtedly grow. To keep a control on inflation is at the core of the ECB’s mandate.”
Brard continues: “That said, however, we do not think that the ECB will have to raise rates. Rising inflation is not what we picture happening. Given what commodity prices and oil have been doing, it is not too surprising to see that inflation is up across the globe. However, take a look at core inflation and there are no problems.”
Another element providing potential support to European bonds involves is more a technical issue concerning underlying investor demand for long dated fixed income bonds. The UK is certainly looking at the issuance of ultra-long gillis up to 50 years, but this is at consultation stage still. “This issue has been much talked about in the market for four or five years, but it has been like the proverbial dog that hasn’t barked,” says BGI’s Connell. “However we think that 2005 will be the year when this talked-of increased demand for 30-year assets is actually seen. As we know the 10-30 year spread is very directional and tends to steepen as yields rally and flatten as bonds sell off and yields rise. We believe that the pent-up demand for long bonds will cause yield curves to flatten whatever the market’s direction.”
“Within Europe there is a massive under-investment in bonds,” states Louanges. “Or put another way there is a huge duration-short in the market. As well as the asset management community who have been short and lost money, the pension funds and insurance companies are underweight bonds in terms of their respective asset allocation. For the pension funds, new regulations are forcing them to decrease the mismatch between their assets and liabilities. We have already seen this process happening in Denmark and is now underway in the Netherlands.”
“The insurance industry will be working to reduce volatility and reduce the mismatch between their assets and liabilities,” continues Louanges. “The easiest way for any investor to increase duration is to go long. And they also have to go for yield to keep the guarantees they’ve made on their policies. The more yields in general stay low, then the more likely it is that yield curves will flatten.”
As for yield spreads between the Euro-zone government bond markets, these are now exceptionally narrow. Brard agrees, saying: “Yes, inter-country spreads are very narrow but we should not see this as an automatic deterrent to invest in slightly higher yielding markets. For example, we feel comfortable with the Greek bond market in which we are invested.”
Pimco’s Louanges agrees that narrow spreads should not be the only reason to not invest in a particular Government bond market and cautions against ignoring them. “There is currently very little differentiation between the (Government) bond yields, but investors would be wrong not to discriminate between differing credit risks. At Pimco we have some significant under- and over-weight positions within the Eurozone markets. With the very low cost of carry we can afford to implement a strong view without losing too much yield.”