The Grand Old Duke of York
In the nursery rhyme, the Grand Old Duke marched his soldiers up and down the hills. Bond markets have felt like that in recent days – although a more modern analogy might be flying in an airplane which hits an air pocket and lurches down in a rather unnerving manner before recovering itself.
The bare facts are that the US 10-year bond yield collapsed as low as 1.15% a few days ago, although it has recovered back just below 1.3% at the time of writing. Expectations for the first US interest rate move continue to oscillate back and forth but have shifted once again to spring 2023. UK 10-year gilt yields followed a similar path, down as low as 0.53% before recovering about 10 basis points. The German bund yield has returned to minus 0.4%, its lowest since February, and indeed the entire German curve is in negative territory out as far as 30-year bonds. Flatter yield curves are the order of the day, suggesting more muted growth and inflation concerns ahead.
Why was this? As ever there is an array of explanations, after the event. The first relates to the pandemic. Delta variant fears are growing as various countries, not just the UK but, for example, Australia, Indonesia, and the Netherlands, witness a spike in cases. This rippled through to concerns about lockdowns, retail spending, travel and tourism. It also added to existing worries about the dislocations to manufacturing production, for example from a shortage of computer chips. On top of that there is the continual debate in the US Congress about whether it can proceed with another mega-fiscal package; at present the likely outcome is relatively smaller and later than previously hoped. Last, but not least, signals that the Chinese economy is slowing added to the mix.
Another way of examining the performance of asset prices is to look at capital flows, within a country or across borders. In recent weeks, there was a steady stream of money into equity markets – the main question for investors was whether to buy expensive US or cheaper European and Asian assets. Such flows came to an abrupt halt on July 19th, which witnessed the sharpest daily drop in equity markets for 3 months. In times of uncertainty, investors rush to safety in bonds – and this occasion was no different. It was a short-term alarum, however, as the ‘buy on the dips’ mentality remains embedded amongst equity investors. A positive US corporate earnings season has helped calm nerves.
Putting aside such short-term market turmoil, each day gives central bankers an opportunity to fine tune market expectations. There were interesting statements from several MPC members this week; both Catherine Mann and Jonathan Haskel made dovish statements about tapering, while Ben Broadbent is “not convinced that the current inflation in retail goods prices should mean higher inflation 18-24 months ahead”. Potentially more influential was the ECB’s monthly meeting, as it provided some much-anticipated commentary explaining how it would interpret its recent strategy review. Such statements matter when a giant block of negative yielding European debt acts as an anchor for the rest of the world.
The underlying problem facing the ECB is the European economy is not expanding swiftly enough. The outlook is indeed positive, as shown by the European Commission’s upbeat survey of business confidence. Indeed the Bundesbank thinks the German economy might return to its pre pandemic size this coming quarter. However, demand for labour is only slowly chipping away at high unemployment – 8% on the official measure, or closer to 11% after taking account of millions on job support schemes. Against that backdrop, while headline inflation has edged above the ECB’s target, core inflation excluding food and energy remains stuck in the tramlines growing around 1% a year.
Where next for the bank? A few weeks ago it published the results of its strategic review, announcing marginal changes in its objective. The inflation target has moved from ‘below but close to 2%’ to ‘2% in the medium term, with modest deviations in either direction’. This week, there was more detail for investors to examine. The key aspect is that interest rates will not be changed until inflation reaches 2% durably over the forecast period. As the bank only forecasts inflation running at 1.4% next year, this suggests that the earliest rate move would be in 2023, and some economists are talking of 2024. The decision to continue with the current level of bond purchases either means that there will be a dramatic tapering programme at the end of the year, or much more likely the planned end to QE in spring 2022 will be pushed back in time.
The ECB has followed the Bank of Japan down the path of negative interest rates and a hefty asset purchase programme. This matters for bond markets. At the end of the day, investors are pricing negative official European interest rates for years to come. Barclays’ research has estimated that the ECB’s QE programme has reduced bond yields by 1.25%. The dead weight of central bank policy continues to restrain bond markets, despite any short-term turbulence.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making