Europe's bond market rout may not be over

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After declining for the first four months of the year German 10-year bund yields have risen sharply over the past month. Having bottomed at less than 0.05% in mid-April, they have since soared, rising to a high of 0.796% on May 7 before slipping back to around 0.7% overnight.

The recent evolution of Germany’s yield curve is revealed below, courtesy of a chart supplied by Moody’s Analytics.

The yield curve of April 13, shown in purple, looks very different to that of a month later, portrayed in red. 10-year yields are now almost 50bps higher while longer-dated 30-year yields have jumped close to 80bps.

While valuations and reduced liquidity on the back of extreme one-way market positioning have contributed to the sharp increase yields, improved expectations for German economic growth and inflation have also contributed to the move.

The following chart shows how growth expectations have improved dramatically over the past month, contributing to the increase in bund yields.

Moody’s Analytics Economist Ben Garber explains the improved outlook for both Eurozone and German growth expectations.

“Eurozone first-quarter growth rose at the seven-quarter high rate of 0.4%, which confirms rising expectations for growth in the region. Analysts have been increasing their projections for this year’s expansion, with the consensus now seeing the Eurozone growing 1.5%, up from a forecast of 1.2% in February. Germany had seen an even wider climb in projections for its growth in 2015 prior to the GDP release, with the consensus forecast for real growth rising to 2.0% in May from a low of 1.3% in January. The composite Markit Eurozone PMI for April of 53.9 is just marginally under March’s 11-month high of 54.0, which bodes well for output growth in the region in the current quarter. Additionally, though unemployment in the Eurozone remains widespread at 11.3% in March, it was down from 11.7% one year ago. These signals point to accelerating activity as the Eurozone exceeds diminished expectations. Sustained upside economic surprises will limit the need for policy easing, and can continue to translate into higher bond yields”.

Accompanying the improved sentiment towards economic growth, expectations for inflation have also increased over the past month. The chart below tracks the evolution in German 5 and 10-year “breakeven” rates, the difference between nominal bund yields to those for inflation-protected securities of the same maturity.

The 10-year “breakeven” rate, shown in yellow, has risen from a low of less than 0.6% in January to more than 1.3% at present, reflecting market expectations for annualised inflation of 1.3% over a 10-year horizon.

While still fractional moves compared to historic norms, they highlight current vulnerabilities across European credit markets. Moody’s Garber elaborates further.

“The deep debt market rout of recent weeks highlighted two very vulnerable areas of the credit markets — government and long-term debt (Figure 5). European government debt in the Barclays index saw a peak yearto-date return of 4.6% on April 15 reduced severely to 0.2% by May 13. And government debt with maturities over ten years produced even more extreme moves, with a peak year-to-date return 12.1% falling to just 0.9% over the same time period. Miniscule yields and long durations proved to be a deadly combination when the one-way bet on an extended euro bond rally went the wrong way. Corporate debt returns narrowed by a much smaller amount in the market reversal, with their peak year-to-date gain of 1.8% falling to a loss of 0.1% by May 13. Investors are encouraged to pick up credit risk in order to reduce still exceptionally high interestrate risk. If the Eurozone recovery continues to surprise on the upside, a cautious approach to rate risk will prove prudent”.

The chart below demonstrates how hefty gains in European debt this year, particularly for long-term Euro government bonds, have evaporated as a result of the small-yet-significant rise in yields.

While the recent strengthening in the Euro will act as a headwind to further increases in growth and inflation expectations, should the US economy regain its footing in the months ahead, extreme-one way market positioning could yet again see yields rise as growth and inflation expectations turn.

While the ECB will likely be there to mop up some of the supply as part of their quantitative easing program, a lack of buyers elsewhere could see capital gains of earlier in the year turn to painful losses should the US economy recover, and the Federal Reserve raise rates, as many market analysts continue to foresee.

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