Rising yields: Another cry for (ECB) help
Gyrations in government bond markets in recent days have caught investors’
attention. We recap the drivers behind the reversal in interest rates and
attempt to pin a fair value tail on the Bund donkey. We see higher yields as a
distinct possibility in the short-term, if the European central bank fails to step
up purchases
Source: Shutterstock
Content
We still have a downward bias in rates
-Upside down: ECB steps out and fiscal policy steps in
-Where to now? Awaiting the ECB
-Pinning a fair value tail on the Bund donkey
-We still have a downward bias in rates
First things first, if we foresaw the sharp drop in interest rates at the beginning of March on the back of coronavirus concerns, we were caught off-guard by the subsequent rebound.
We have long believed that interest rates, particularly in the eurozone, react asymmetrically to shocks. They drop more on bad news than they rise on good news. We could spend many paragraphs explaining why, but the crux of our argument centres on secular growth and inflation slowdown, heavy central bank intervention, and deficient fiscal policy.
Upside down: ECB steps out and fiscal policy steps in
Economic and Financial Analysis
Rates18 March 2020
Borrowing costs are rising fast
Source: Bloomberg, ING
Two of these assumptions have been dramatically challenged in the past weeks.
Firstly, the latest European central bank meeting confirmed something we have warned about since the end of Mario Draghi’s term: more hawkish ECB communication. Too much has been made of Christine Lagarde’s ‘closing the spread’ comment, and these were quickly rowed back. However, the market thinks the size of the additional €120bn envelope in itself betrays either a misunderstanding of how central the ‘ECB put’ is in pricing European fixed income markets or a willingness to let market prices be less dependent on central bank actions.
As things stand, we think it is a stretch to expect eurozone
governments to send cheques in the post to their citizens, but it
can't be completely ruled out
The third assumption we made has also been challenged too. The severity of the economic impact caused by the coronavirus pandemic has prompted a strong fiscal response. The sums discussed have quickly inflated. The US response in particular, with a $1tn+ package, had markets assume the possibility of similar measures in Europe seriously.
As things stand, we think it is a stretch to expect Eurozone governments to send cheques in the post to their citizens, but it can't be completely ruled out.
Where to now? Awaiting the ECB
Tactically, one key concern has been the breakdown in the correlation between Bund yields and equity prices.
It should be noted that there have been dislocations for some time now as bond markets were much quicker to price the economic risk posed by the pandemic (in line with our bias towards lower rates above).
More recently, the palpable economic gloom has continued to weigh on stocks while interest rates rose in response to fiscal easing. In the past, episodes of falling stock prices and rising yields have coincided with a rise in inflation expectations. This clearly does not apply here in our view.
Going forward, we think of central bank intervention as a prop to both bonds and stock markets. The corollary to this view is that we can continue to see both bonds and stocks falling (i.e.
Correlation between stocks and bonds has broken down
Source: Bloomberg, ING
higher interest rates) as long as the ECB does not step in with more aggressive purchases. Assuming no further ECB intervention is forthcoming, and fiscal easing materialises, we could see Bund yields rise to -0.15% in the near-term.
Any confirmation that the ECB doesn’t intend on supporting the market would propel Bund yields to 0%. As we explain below, we fail to see a fundamental justification for such levels so we would expect a subsequent reversal towards lower yields.
Pinning a fair value tail on the Bund donkey
So where does this leave interest direction in the long run? Well, we are not convinced that either the ECB will stay on the side-line, nor do we expect a US-sized fiscal package in the Eurozone. Since so many things are up in the air, we revert to a good old scenario analysis to see the impact it would have on Bund fair value.
We assume three scenarios:
1. Current unstable equilibrium of no concrete fiscal measures and insufficient ECB intervention 2. Large fiscal package but no further ECB intervention
3. Large fiscal package and ECB reverting to its Draghi reaction function.
In each case, we make fairly aggressive assumptions in order to highlight the impact each would have on interest.
Our fair-value estimates for year-end 2020 range from -0.55% (fiscal easing with no further ECB action) to -0.82% (aggressive ECB easing).
The current situation would justify rates dropping to -0.70%. To be clear, none of these is our official forecast but they illustrate that barring a quick economic recovery, we struggle to justify Bund yields staying at our -0.15% short term target, let alone 0%.
10-year Bund fair value: Not rising in a hurry
Source: Bloomberg, ING
Antoine Bouvet Senior Rates Strategist +44 20 7767 6279
Disclaimer
This publication has been prepared by the Economic and Financial Analysis Division of ING Bank N.V. ("ING") solely for information purposes without regard to any particular user's investment objectives, financial situation, or means. ING forms part of ING Group (being for this purpose ING Group NV and its subsidiary and affiliated companies). The information in the publication is not an investment recommendation and it is not investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Reasonable care has been taken to ensure that this publication is not untrue or misleading when published, but ING does not represent that it is accurate or complete. ING does not accept any liability for any direct, indirect or consequential loss arising from any use of this publication. Unless otherwise stated, any views, forecasts, or estimates are solely those of the author(s), as of the date of the publication and are subject to change without notice. The distribution of this publication may be restricted by law or regulation in different jurisdictions and persons into whose possession this publication comes should inform themselves about, and observe, such restrictions. Copyright and database rights protection exists in this report and it may not be reproduced, distributed or published by any person for any purpose without the prior express consent of ING. All rights are reserved. ING Bank N.V. is authorised by the Dutch Central Bank and supervised by the European Central Bank (ECB), the Dutch Central Bank (DNB) and the Dutch Authority for the Financial Markets (AFM). ING Bank N.V. is incorporated in the Netherlands (Trade Register no. 33031431 Amsterdam). In the United Kingdom this information is approved and/or communicated by ING Bank N.V., London Branch. ING Bank N.V., London Branch is deemed authorised by the Prudential Regulation Authority and is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. The nature and extent of consumer protections may differ from those for firms based in the UK. Details of the Temporary Permissions Regime, which allows EEA-based firms to operate in the UK for a limited period while seeking full authorisation, are available on the Financial Conduct Authority’s website.. ING Bank N.V., London branch is registered in England (Registration number BR000341) at 8-10 Moorgate, London EC2 6DA. For US Investors: Any person wishing to discuss this report or effect transactions in any security discussed herein should contact ING Financial Markets LLC, which is a member of the NYSE, FINRA and SIPC and part of ING, and which has accepted responsibility for the distribution of this report in the United States under applicable requirements.