Long-term rates rise....but it is not yet a bond crash

The recent sharp rise in long-term rates in Europe relies on a risk pooling across peripheral countries and the entire euro zone. But we cannot yet talk about bond crash.

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In the short term, many macroeconomic, regulatory and psychological factors could lead a new decline in long-term rates. The real break on both sides of the Atlantic will coincide with the change of growth pattern in emerging economies.

We’ve recently wrote that long-term rates of the euro zone core (German and French government bonds among others) could not rise in the short term for strong reasons.

- Psychological reason in an environment of risk aversion encouraging the reallocation of portfolios towards euro zone core bonds supposedly - wrongly or rightly - with little or no risk. History will tell us if markets were right to heavily overweight French and German government bonds during crisis periods of risky assets

- Regulatory reason with the anticipation of Basel 3 framework which encourages all investors to increase government bonds allocation as capital consumption of is low if not nil. All this, without even wonder whether those assets are risky or not (future publications will address this ongoing revolution in financial markets with the repricing and reassessment of sovereign risk)

- Strong macroeconomic reasons with the persistence of global excess savings: companies of major market indices do not know what to do with their profits and thus save or redistribute to shareholders with ridiculously high dividends; exporters in Asia and the Middle East reuse their trade surpluses, at least for now, to invest in government securities (for Asian countries, the purpose is to avoid large revaluation of their currencies and continue as long as possible the monetary dumping since growth models still rely on exports)

- Finally reason related to the maintenance of accommodative monetary policy by central banks: we have written that there was a sort of irreversibility which prevents these institutions from increasing their key rates anytime soon. This remains a powerful support for holding government bonds (institutional investors) and offers an incentive to continue the purchase as these bonds are refinanced almost for free and will still be in the future. There would be no risk - or almost - to hold government bonds of countries considered as the most virtuous, and even purchase new ones since the processing margin (the difference between the rate of return on these bonds and the refinancing cost, Eonia or 3-months Euribor, of these securities is profitable and should remain for a long time) ... No risk apart from sovereign issuer failure to refund. It has been a while since we are confident that many sovereign states of the Euro zone (and not just PIGS) will be unable to repay their debt beyond a maturity (2018? 2020?, 2025?) ... This issue will be subject to further analysis.

Anyway, although fragile, artificial and potentially challengeable in the coming years, all these reasons still exist today and curb on short-term a sustainable and structural rise in long-term rates of the government bonds of France, Germany, U.K and U.S.

Similarly, the factors of rising interest rates, in the medium and long term, associated with emerging economies are very far from being active

- The risks of wage inflation in emerging economies linked to stress on production capacities and trade union demands, should not occur in the short term, therefore no imminent transmission of inflation to the West and no real short-term bond market crash

- No imminent change in exchange rate regime in China. Therefore the accumulation of foreign reserves, achieved by issuing currencies to sell against U.S dollar and euro while purchasing government securities denominated in those currencies, should still persist and prevent long-term rates from rising significantly. Happy will be those who will be able to truly anticipate the break in exchange rate regime, thus replace the Chinese growth model based on exports by a model based on domestic growth: it will mean they would have been able to anticipate sharp directional moves in foreign exchange and long-term rates markets.

So finally why did long-term rates of the euro zone core (of course we’re not talking here of long-term rates of peripheral debts in the euro zone) jump so sharply in recent weeks? Let’s see: 10-year Bund 10 at 3.04% on January 14, 2011 against a record low at 2.12% on august 31, 2010; 10-year OAT at 3.40% on January 14, 2011 against a low at 2.47% on august 31, 2010 and similarly 10-year CMS 10 at 3.28% on January 14, 2011 against a record low at 2.33% on august 30, 2010.

- The sharp steepening of the yield curve, following rising long-term rates, looks like Anglo-Saxon steepening with a loss of anti-inflationary credibility of the central bank. It is as if we were expecting that ECB’s behavior would converge with the behavior of the Fed and BOE on quantitative easing. Better still, the markets probably anticipate that ECB will also let go on currency with the acceptance of a depreciation of the euro and inflation imported in the area. In other words, it would imply sharing Greek, Irish and Portuguese impoverishment with the entire area and allowing a general rise in long-term rates within euro zone, including Germany and France, as non-residents will become more demanding on returns on their investments in government securities of the Euro zone following a weakening of the euro.

- This rise in long-term rates in France and Germany may also find its source in an anticipation of another form of pooling: the one behind the massive issuance of Eurobonds by European Financial Stability Fund (EFSF), or the European Financial Stability Mechanism (EFSM) whose size would increase, all with the benevolent neutrality of Germany.

We believe markets are wrong

- First of all, we do not believe that ECB will embrace quantitative easing like the Fed did, and will do anything to avoid implicit devaluation of the Euro

- Second, we also do not believe that Germany will capitulate by agreeing with a pooling of sovereign debt issuances; let alone sustaining a permanent use of the EFSF.

For these reasons (and of course for all those mentioned above), the bond crash is not yet in the agenda of the day; some long-term rates could even decline again: the 10-year German Bund and its satellites (Finnish, Austrian and Dutch government bonds), and to a lesser extent the 10-year French, Italian and Belgian rates; However, we’ll have sustainable risk premiums in Spanish and PIGS 10-year rates; Uncertainties about the 10-year CMS (long-term interbank reference and barometer of banks credit quality)
Globally (topic to be addressed in future publications), we will experience a real repricing of some credit risks (safe sovereign, sovereign under supervision, independent corporate and banks, corporate and banks relying on sovereign with budgetary issues). The scale of risk and returns of different types of issuers will become increasingly complex.

Mory Doré , January 2011

Article also available in : English EN | français FR

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