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Global bond rout not all bad

David Bassanese
Wednesday, May 13, 2015

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By David Bassanese

At first glance, the “rout” in global bonds markets over the past month looks quite ugly and concerning. Since mid-April, the yield on German 10-year government bonds has surged almost vertically, from a closing 0.077% to 0.59%. The intra-day low was a mere 0.05%. Those caught holding large positions in this market have certainly got their fingers burnt.

Source: Thomson Reuters

Bond yields have also spiked higher in the United States, but not to the same extent. The yield on US 10-year government bonds has lifted from around 1.85% to 2.27% over the same period.

Source: Thomson Reuters

It’s never nice to see disorderly market movements, but from a bigger picture view point I still find it hard to get too concerned about the lift in yields. I certainly don’t believe the yield surge points to a sudden lift in inflation fears, or hints that central banks are about to take away the punch bowl too soon.

To the contrary, I view the rise in bond yields as good news – it’s evidence that central bank policy stimulus is working, both to support economic growth and dampen lingering deflation fears.

After all, what should be more concerning is the fact that yields on German 10-year bonds got as low 0.05% in the first place! What’s clear is that investors piled into German bonds from late last year, driven by a widely anticipated announcement from the European Central Bank of a mega bond-buying scheme.

It’s fair to say the ECB’s move to quantitative easing earlier this year was the worst kept secret in financial markets, and led to a very crowded stampede into European bonds.

German bonds earlier this year also represented a safe haven, due to fears of a potential new Greek crisis, and possible blow out in bond yields across the European periphery. The last leg of the rally in German yields from March to mid-April, for example, coincided with a widening in spreads to Italian bonds from 0.9% to 1.4%.

So some perspective is needed – the surge in German bond yields has only taken them back to where they were in mid-December, just as talk over ECB policy easing was heating up. Similarly, the rebound in US bond yields has only returned them to where they were in early March.

As for good news, annual growth in Euro-zone consumer prices was zero in April, lifting from spate of negative readings between December and March – and good tentative sign that deflation risks are receding. This past month the European Commission also bumped up its forecast for Euro zone economic growth this year from 1.3% to 1.5%.

Of course, the abruptness of the move in German yields, in particular, over the past month also suggests being “long bunds” had become a very crowded trade, and also points to some market illiquidity. Indeed, there are suggestions that new regulations in the wake of the financial crisis have made European banks less willing to “warehouse” bonds on their balance sheet as part of their trade facilitation process – meaning the market could not readily absorb the stampede of selling.

Where to from hear? If the European economy is truly getting better, bond yields should likely rise further – ideally, however, this move might be more orderly than we’ve seen in recent weeks. That said, investors should be reminded this is good news – not bad – and a reason to keep the faith with pro-global growth equity exposures.

Similarly, bond yields in the United States also appear to have bottomed – and should continue to move higher as the Federal Reserve inches toward its first official interest rate hike in many years. But again, the Fed will only be raising rates as long as the economy continues to improve.  With ample spare economic capacity in both Europe and the United States, and still subdued commodity prices, a major breakout in inflation remains highly unlikely - which means central banks can afford to be cautious in taking away the punch bowl.

Published: Wednesday, May 13, 2015

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