Market Commentary

Q1 2015

The feature of the first quarter of 2015 has undoubtedly been the dramatic collapse in sovereign bond yields which have now declined into negative territory in no less than 10 countries in Europe. Steep declines in inflation rates have permitted the European Central Bank to implement its massive quantitative easing program (most of Europe is now experiencing deflation). [CHART 1] The ECB’s program includes the purchase of €60bn of bonds each month – a formidable challenge in itself, given the reduced issuance. Even before the purchases commenced, interest rates were driven down sharply in anticipation of this huge increase in demand.

The downward momentum appears to have taken on a life of its own: some €7 trillion of global bonds now have negative yields. Interest rate management, the most powerful and widely used tool of central banks, became impotent when rates had already declined to near zero. The ECB’s solution: simply take them into negative territory!

Most of the negative rates are at the shorter end of the maturity spectrum – up to just below 5 years. However, in Germany, the 5-year yield is already negative. [CHART 2] Pressure at the short end has obviously dragged longer term rates down as well.

Sharply declining rates have obviously caused prices of all categories of listed European bonds to soar. And, last week, Germany actually auctioned off a new 12- month government bill – at a negative rate. This is quite bizarre: borrowing money has actually become a profit centre for some central banks!

Negative rates obviously guarantee losses for buyers who hold them to maturity. So current buyers are clearly betting that the securities will appreciate in price before then (due mainly to ECB buying), allowing them to sell at a profit before they fall due for redemption.

Apart from flooding Europe with liquidity, an integral part of the ECB’s program is to significantly weaken the euro. [CHART 3] Indeed, managing currencies downwards is becoming the dominant policy tool of many countries, now that rates are already so close to zero. Investment flows out of Europe will soar as individuals and institutions search for yield, propelling the euro ever lower. The US, where rates are already significantly higher and poised to rise in the near term, is the prime beneficiary. The spread between euro rates and US treasuries is at an all-time high. [CHART 4]

The gap between real yields in the US and those prevailing in most other major countries, is likely to widen further once the Fed starts raising rates. The process will be gradual and should not exert undue pressure on long term rates due to reduced issuance and growing demand from offshore investors chasing higher yields. This will be beneficial to equities as bonds will, as a result, remain decidedly unattractive. The dollar bull market will also continue as higher rates, and a strong currency, will remain an irresistible combination to offshore investors.

Although equity markets appear somewhat stretched compared with historical averages, they remain undeniably cheap compared with fixed interest alternatives. Corporate balance sheets have never been stronger, pension funds and insurers’ investment in equities is relatively low and cash levels are high. Insurance companies in the US, for example, had an average exposure of 19% to equities in 2007. This fell to 5% in 2008 during the global financial crisis and remains at that level today. The great rotation from bonds to equities could still have some way to go.

Global financial markets are clearly in unchartered waters and the eventual outcome for bond markets, in particular, is unlikely to be pretty. The impact on equity markets could be quite positive while global interest rates remain close to all-time lows. Indeed, the search for yield, the aversion to fixed interest, and the low equity exposure of insurers and pension funds could see equities blow out into bubbleland. (Not our base case but not implausible either.)