Making Sense of the Selloff

Transcription

1 Making Sense of the Selloff Steven Friedman, Director, Central Banks & Official Institutions Cedric Scholtes, Head of Global Rates & US TIPS Portfolios May 2015 The early stages of quantitative easing (QE) in developed markets tend to be associated with currency depreciation, lower long-term rates driven by a collapse in the real term premium, and a rally in risk assets. As discussed in a recent weekly commentary, the ECB s January QE announcement led to market effects that were consistent with, and in some respects stronger than, the QE experience elsewhere. But to the likely dismay of ECB policy makers, much of these effects have reversed over the past three weeks, as the euro strengthened six percent against the dollar, the Euro Stoxx index declined close to seven percent, and 10-year sovereign bond yields rose to levels last seen in December. Overall, financial conditions in Europe today are now only marginally easier than they were at the time of the ECB s QE announcement in January. In our view, the reversal of QE trades is largely a positioning adjustment from stretched valuations, and has very little to do with any fundamental change in Europe s macroeconomic outlook or the ECB s commitment to QE. As such, and putting aside for a moment the risks related to Greece, we expect European yields to stabilize around current levels given our skepticism that ECB QE will radically shift the European growth and inflation outlook absent more aggressive structural reforms and pro-growth fiscal policy. INFLATION BOOST - MISSION ACCOMPLISHED? QE works in part by driving down real rates of return on sovereign debt, leading investors to seek higher returns on other assets. However in its early stages QE tends to lower nominal yields as well, because the decline in real rates offsets any increase in inflation compensation. Over time, if the public believes that QE is leading to a sustainable shift in the inflation outlook, the rise in inflation expectations would feed through to higher nominal yields. With this framework in mind, one critical observation from the sharp rise in European nominal yields since mid-april is that 10-year Eurozone inflation swap rates have increased only modestly over the same time period, implying that real yields have risen sharply. In addition, survey-based measures of inflation expectations have not increased significantly since the launch of ECB QE. The ECB s own Survey of Professional Forecasters saw median expectations for year-end 2017 inflation rise to just 1.6 percent in the most recent survey, up from 1.4 percent in the survey conducted during the fourth quarter of last year. These relatively modest moves in market-based measures of inflation compensation as well as survey data indicate that the rise in European sovereign yields has not been driven by conviction that QE has prompted a regime shift in the inflation outlook. Declines in European stock markets also suggest that the rise in yields is not due to an increasingly positive outlook for growth and inflation.

2 Making Sense of the Selloff May LACK OF ECB COMMITMENT? Some market commentators suggest that growing concern that the ECB will not complete its announced purchases contributed to the rise in Eurozone yields and the broad tightening of financial conditions. This concern could stem from a perceived lack of commitment to the program among Governing Council members, or if the Council had significantly upgraded its inflation outlook such that an early end to asset purchases would be warranted. We view these explanations as extremely suspect. In his last postmeeting press conference, President Draghi made clear that not only does the ECB intend to complete its announced purchases, but that purchases could extend beyond September 2016 if inflation is not on a sustainable path to the ECB s target. Comments from other Governing Council members have been consistent with this message. In addition, growth and inflation data in the Eurozone have not materially improved to the extent that Council members would contemplate an early end to asset purchases. In fact, Council members are fully aware that other central banks, particularly the Federal Reserve, ended early rounds of QE prematurely and damaged economic prospects. The ECB likely understands this key lesson from the international experience, and that any signal of an early end to purchases would only jeopardize the attainment of their policy objectives through a tightening of financial conditions. STRETCHED VALUATIONS AND CROWDED POSITIONING While we believe that the Eurozone was the catalyst behind the sharp increase in developed market bond yields, our explanation tends more towards a sharp unwind of QE trades once bond yields fell well below fair value metrics, with crowded positioning and other market dynamics amplifying the move. While it is difficult to identify a specific catalyst for the unwind, one possibility is that public comments by some fund managers about stretched valuations led other investors to take profits as core Eurozone sovereign yields fell close to or further into negative territory. The following factors also likely contributed to the decision to pare long positions in Eurozone sovereign bonds, or to the severity of the move once yields began to rise: The approximately 20 percent increase in front-month Brent crude oil futures prices since mid-march contributed to an increase in Eurozone inflation compensation and reduced the probability that bond investors attached to further declines in long-term yields. This less attractive risk-return tradeoff led to position unwinds, and the higher yields served as a catalyst for euro appreciation and pressure on risk asset prices. Investors and traders keep close tabs on sovereign debt supply calendars, so absent any surprises in issuance, supply considerations would not serve as a strong catalyst for such a sharp move in rates. Still, investors have long understood that the supply calendar net of QE was set to ramp up, and swing from roughly -$40 billion euro in net issuance in April to a similar but positive figure in May. As forthcoming supply increases can lead to a price concession, some shortterm investors likely decided to reduce long positions in advance of new issuance. On the margins, a few surprises in net supply may have also affected market sentiment. These include the growing awareness that some sovereigns may take advantage of low rates to term out the maturity of forthcoming new issues, or the realization that a number of the national central banks (and the Bundesbank and the Banque de France in particular), have made QE purchases at shorter average maturities than the average maturity of their national bond markets. Both of these net supply surprises add more duration to the market than investors otherwise expected, and increase the risk premium for holding sovereign bonds. Systematic hedge funds and other investors that employ momentum strategies likely suffered sizeable losses as rates began to rise, and were forced to unwind positions to preserve capital. These strategies often use leverage, which implies the potential for significant drawdowns if positions are not quickly reduced. Other investors, even if not engaged in leveraged or systematic strategies, may also have quickly reduced positions as the move higher in yields gained momentum. This could have occurred due to VaR breaches or an increase in bond price and equity correlations, which may have led some investors to reduce long bond positions that had been used to hedge equity holdings. We have previously mentioned that the -20 basis point floor on ECB bond purchases contributed to the sharp decline in long-term sovereign yields and significant curve flattening. As yields on shorter-dated securities approached the floor, investors came to expect that the Eurosystem would need to shift purchases further out the yield curve. Unfortunately, the same dynamic works in reverse. The recent rise in shorterdated yields frees up more securities for Eurosystem purchases, and reduces the likelihood that purchases will have to extend further out the curve. For example while three weeks ago bunds out to 4 years maturity were trading at or below the -20 basis point floor, now bunds with maturities beyond two years are trading above the floor and eligible for purchase. This implies potentially less duration removed from the market via central bank purchases. This dynamic feature of the ECB s program is quite different from other QE programs, where movements in yields did not imply self-reinforcing shifts in the composition of central bank purchases.

3 Making Sense of the Selloff May WHAT HAPPENS NEXT? As noted above, we do not view the rise in Eurozone spot and forward yields as reflecting broad-based conviction that ECB QE will succeed in reflating the Eurozone economy. Survey-based measures of inflation expectations show little confidence that inflation will return to the ECB s target by the end of 2015, and we generally share this skepticism. In the years ahead, aggregate fiscal policy will remain tight as many sovereigns must still engage in significant deleveraging. And progress on structural reforms in some peripheral countries has been slow. In addition, it will be difficult for inflation to move considerably higher over the next two years as the Eurozone s negative output gap will persist over this time period. Global inflation pressures also remain muted given growth below potential in many large economies including China, an important Eurozone trading partner. sheet policy that add duration to the market after liftoff could also begin to pressure term premia later this year. Finally, and while certainly not our central scenario, any communications error by the ECB that appeared to lessen the commitment to QE would also risk a move to much higher rates. Against this backdrop, we see little reason to expect the recent selloff in Eurozone sovereign bond markets to continue. While there is a range of views across the investment team, we benchmark our expectations for the average ECB policy rate over the next decade at roughly 75 basis points. Assuming the ECB continues to engage in financial repression for several years through a mix of QE and forward guidance, it is not unreasonable to suspect that the term premium will remain close to or even below zero for the foreseeable future. This would benchmark fair value on the 10-year bund yield at 75 basis points, compared to the current level of 65 basis points. In forward space, where yields should be tied to trend nominal growth expectations, valuations appear a bit more stretched even after the recent sell-off. Assuming trend Eurozone real growth of 1.0 percent and inflation of 1.5 percent, the current nominal 5y5y bund yield of one percent remains well below long-run equilibrium. But since this is precisely the intention of unconventional policy, low forward rates can persist absent a change in the growth and inflation outlook or a shift in the ECB s policy reaction function. We also cannot dismiss the possibility that low forward rates in the Eurozone reflect expectations that the ECB will struggle to achieve its inflation target over the long term. To summarize, the combination of deleveraging, low levels of domestic and global inflation, and aggressive use of unconventional policies should continue to suppress Eurozone sovereign yields. Still, we need to be attentive to factors that could lead to further sharp increases in yields. One important factor would be a continued rise in oil prices, particularly if driven by a pickup in global demand, as this would lead to higher inflation expectations. In addition, the approach of policy liftoff in the United States will initially increase market uncertainty and lead to higher term premia across sovereign bond markets. Potential changes to the Federal Reserve s balance

4 Making Sense of the Selloff May BIOGRAPHIES Steven Friedman Director, Official Institutions FFTW Steven is a member of the Central Banks and Official Institutions team responsible for client service and business development. He joined FFTW in 2013 and is based in New York. Before joining FFTW, Steven held various positions within the Markets Group at the Federal Reserve Bank of New York, most recently as Director of Market Analysis, where his work focused on assessing market expectations for monetary policy. Prior to that, Steven worked as Director of Foreign Exchange and Investments, where he had oversight for the Federal Reserve s and Treasury s foreign exchange portfolios. During the financial crisis, he worked on the design and implementation of a number of liquidity facilities, such as swap lines with other central banks, agency debt purchases and the commercial paper funding facility. Steven also spent two years at the Bank for International Settlements as a member of the Basel Committee Secretariat. He has over 16 years of market related experience. Steven holds a BA in government and Russian studies from Wesleyan University (1993), an MA in international relations from The Paul H. Nitze School of Advanced International Studies at The Johns Hopkins University (1998), and an MBA (executive program) from Columbia Business School (2011). Cedric Scholtes Head of Global Rates & Head of US TIPS Portfolios FFTW Cedric is Head of Global Rates and Head of US TIPS Portfolios at FFTW. He is responsible for the overall performance of the Global Rates team, implementing and improving investment processes for this team as well as managing the dedicated interest rate specialists who comprise the team. He also has responsibility for overseeing US inflation-linked portfolios as well as US government portfolios, including generating alpha ideas within US rates and inflation markets for implementation across applicable portfolios. Cedric joined FFTW in June 2006 as a portfolio manager and is based in New York. Cedric joined the firm from the Treasury trading desk at Goldman Sachs, where his responsibilities included taking proprietary positions and market-making in index-linked markets, as well as enhancing the desk s analytical capabilities. Prior to working at Goldman Sachs, Cedric spent five years at the Bank of England, two of which were spent on secondment to the Federal Reserve Bank of New York. At the Bank of England, Cedric spent two years in the Foreign Exchange Division, helping to manage the UK Treasury s foreign exchange reserves. Prior to that, he worked as a research economist within the Monetary Analysis Division, researching fixed income markets. Cedric has published articles on nominal and inflation-linked debt markets in Bank of England, BIS and IMF periodicals, as well as RiskBooks. Cedric has 15 years of investment experience. Cedric holds an MSc in finance and economics from Warwick Business School (1999), an MSc in economics from the London School of Economics (1997), and an MA/BA in economics from Cambridge University (1996).

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