How can we justify benchmark German bond yields at 0.7 per cent, the lowest in their recorded history? This is a key question for investors to address, not just in relation to their holdings of eurozone assets. The implication of what is happening in Europe will matter considerably for other regions into 2015.
Many explanations have been put forward for the violent market corrections in October, but one area does appear to be the epicentre – namely Europe. Worries about the strength of the German economy, combined with fears about the lack of reforms in France and Italy, plus the stirring of political tensions in Greece, all caused investors to pull risk off the table, hence the DAX index falling almost 15 per cent peak to trough. Stepping back, German bond yields started the year at 2 per cent, so today’s levels of about 0.8 per cent leave them only 0.4 per cent above those offered in Japan. Is Europe entering ‘Japanisation’, an entrenched period of deflation?
Stepping back from the problems of 2014, let us look over the past few years. A new regime has appeared, one where asset prices are increasingly driven or determined by official edict rather than by the voluntary decisions of buyer and seller. Quantitative easing – unconventional monetary policy altering the normal demand and supply balance in government bond markets – has serious implications for capital flows. Yes, there are retail and institutional investors who build up capital or look for income opportunities. After all, current European yields are still positive in real terms against the backdrop of eurozone headline inflation, which is only running at 0.3 per cent a year. However, there are many investors, whether sovereign wealth funds, central bank foreign exchange reserve managers, or pension fund trustees, whose freedom of manoeuvre is seriously limited by this new set of rules. QE has raised the prices of many assets well away from fair value. We have to remember that, ultimately, we are trying to create decent nominal and inflation-adjusted returns for our clients. This is proving difficult in many areas of fixed income; at the time of writing, 10-year government bond yields are not only low in Japan and Germany, but also the US and UK, not far above 2 per cent. What sort of long-term returns can be expected from investing in such expensive assets?
A simple way of answering this question is not to look at Europe, but ask whether or not the Bank of England’s Monetary Policy Committee and the US Federal Reserve are actually able to start raising interest rates in 2015. If they can, then their business cycles have allowed sufficient growth and wages or consumer inflation to appear. On that basis, the medium-term assessment would be for rather higher bond yields – at its simplest, 2 per cent trend growth plus 2 per cent core inflation plus a risk premium would suggest US and UK bond yields broadly double their current levels.
Correlations between global bond markets remain rather tight. The implications of US and other global developments are rather important for Europe. Shifts in monetary policy expectations are already causing the Euro to depreciate. This should begin to affect import prices, helping to drive eurozone inflation back towards 1 per cent a year for 2015, as well as supporting stronger exports to a thriving US consumer. The uptrend should be helped especially by the rise in German minimum wages from January 2015 which will have a noticeable effect on the consumer price index. Second, the latest demand/supply shift in the oil market has caused a fall in prices. This will also have implications for the CPI, which needs assessing, but on balance it should feed through into higher real wages and thus consumer spending, as well as better margins for European companies. Lastly, there is the potential for European credit growth to pick up into 2015. The European Central Bank’s comprehensive assessment could – finally – start a process whereby lenders are more willing to extend borrowing, helped by the targeted longer-term refinancing operations measures introduced by the central bank. All in all, even in Europe, a successful ECB engineering some expansion in inflation back towards target rather than towards zero would expect to see mainstream eurozone bond yields closer to 2 per cent than 1 per cent.
