The very low level of yields for benchmark bonds is a striking feature of the current economic cycle. At the time of writing, yields on the 10-year German Bund are at 2.13%, French bonds are not far behind, at 2.47%, and those for the UK stand at 2.90%. As Figure 1 shows, those are the lowest levels observed in the past 20 years. Yet, such low levels are being observed despite the fact that government issuances continue to rise – representing over two thirds of global issuances this year according to our estimates.
Source: Reuters Datastream
Several factors help to understand this new ‘conundrum’ – with yields staying at historical lows despite rising issuances. First, a breakdown of the overall demand for bonds reveals that so far the rise in the private sector (corporates, but especially households) savings has helped maintain a balance between supply and demand, thus preventing yields from going up, although the contribution from central banks to demand diminished since last year. How long can we expect low rates to prevail? Will there continue to be enough savings to absorb new issuances, particularly from governments?
Second, low yields also reflect market expectations that inflation will remain benign in the medium term. Is that also a realistic anticipation?
A Breakdown of Demand and Supply on Global Bond Markets: Preparing for Life Without ‘QE’
2009 will be remembered in economic chronicles as an exceptional year from the point of view of global bond markets. Supply reached over US$5.5 trillion, of which governments accounted for US$3 trillion and yet, on average, benchmark rates declined by over 50 basis points (bps) from a year earlier. Large non-financial companies were quick to take advantage of those very attractive funding conditions, issuing over US$1.5 trillion of bonds. To understand why this flurry of new issues did not cause interest rates to rise, we need to look at the demand side of the equation. Estimates put together by J.P. Morgan, an investment bank, reveal that OECD central banks played a major role. Through their quantitative easing (QE) policies, the Federal Reserve, the Bank of England and the Swiss National Bank bought some US$2 trillion of bonds on the primary markets. Commercial banks came as the second largest buyers (US$1 trillion) The critical contribution from the central banks, massive as it was, isn’t a total surprise. QE was introduced at the end of 2008 as one of the two legs (the other being ultra low policy rates) of the new monetary strategy aimed at avoiding a replay of the Great Depression of 1929. And indeed, between September 2008 and the middle of 2009, the balance sheet of the Federal Reserve doubled in size.
But equally, QE was described right from the start as a temporary measure. As soon as the affected economies began to show signs of a revival, central banks would put in place ‘exit strategies’, mopping some of the liquidities previously injected and gradually normalising their policy rates. This is indeed what has now started to happen: the Bank of England announced in the early part of this summer that QE was suspended, as did the Federal Reserve (the latter didn’t completely rule out more QE given the still very weak US economy). A major pillar supporting demand on bond markets is going to be progressively removed. Yet, as noted above, so far yields have continued to decline, shrugging off such a development. In my opinion, this is for two main reasons:
First, global supply in 2010 is down from 2009. Government issuances should slightly exceed their level of 2009 (to reach US$3.2 trillion by our estimates) but the volume of corporate issuances should only amount to a third of last year’s levels. This is because 2009 provided a great opportunity for corporates to refinance some of their debt at better conditions. 2010 is, in that sense, an ‘intermediate year’ before volumes start to rise again in the next couple of years, according to projections. Overall supply on global bond markets should amount to about US$4 trillion this year (compared to US$5.5 trillion in 2009).
Second, besides OECD central and commercial banks, demand in 2009 and in the first half of this year was supported by emerging market (EM) central banks, reinvesting their foreign exchange (FX) reserves (purchasing US$400bn of bonds last year, according to J.P. Morgan estimates) and by retail bond funds (whose demand reached US$800bn last year). Looking forward, EM central banks are likely to continue to play a significant role on bond markets, as EM economies’ trade surpluses rise again. Down the road, they may invest more and more in their own regions, to respond to growing financing needs. They may also become increasingly selective in their investment choices as far as government securities are concerned. But those developments are likely to be gradual. Meanwhile, one can expect continued strong demand from that sector.
That leaves us with retail bond funds and, more broadly, the question of private savings being rechanneled into the international capital markets. Across most developed markets, private savings rates increased significantly last year, especially in those economies where they had previously reached very low levels (the US, the UK, Spain.). The surge in unemployment and the prospects of tighter fiscal policies incentivised households to put a lid on their spending. At the same time, the non-financial corporate sector has improved its overall financial position, as measured by its financial gap/surplus (the difference between their savings and their investments). In the UK, for instance, the corporate sector’s financial surplus has jumped to 4.5 % of gross domestic product (GDP) in the first quarter of this year from 2.6% a year earlier.
Looking forward, the outlook for net private savings depends on the future path of the economic recovery in the industrialised countries.
A Sub-par Economic Recovery
The most recent economic indicators confirmed that growth accelerated throughout western Europe in the first half of the year. GDP increased by 1% in the eurozone during the second quarter and by 1.7% from a year earlier. This push has been primarily driven by the two largest economies of the eurozone, Germany and France. The German performance was particularly impressive, with GDP growing 2.2% quarter-on-quarter and 3.7% year-on-year. This strong result, coming after 1.6% year-on-year in the previous quarter has led us to raise our forecast for the eurozone’s GDP to 2.5% this year (from 2% previously) and 2.3% next year (from 2%).The UK results were also surprising, with GDP growing by an impressive 1.6% year-on-year annualised terms, its strongest quarterly performance in nine years.
At the same time, the rest of Europe, particularly the southern rim (along with Ireland) continues to look weaker. Spain’s GDP was down 0.2% year-on-year in the second quarter. Greece’s was down 3.5%. The divergence is particularly stark in services: the service purchasing managers’ index (PMI) for Italy, Spain and Ireland all showed a sharp deceleration at the beginning of the summer.
Those developments support our forecast of a two-tier recovery in western Europe. We expect growth to slow down in the final quarter of this year and in the first six months of 2011. Broader-based fiscal tightening will weigh on domestic demand, while elevated unemployment will continue to reduce real income growth. At the same time, we continue to believe that the current recovery is going to be sustained, even if it looks rather weak compared to previous recoveries.
The strong surge in world trade was a major factor in explaining the recovery in manufacturing growth in Europe. Between September 2008 and May 2009, world trade contracted in real terms by 20%, the largest decline in over 30 years. Since then, however, the bounce-back has been impressive. The uplifting was mainly due to emerging market imports, especially in Asia. The fiscal stimulus packages implemented early last year in China, South Korea, Malaysia and Thailand contributed to a revival in domestic demand in the region and in turn propped up import growth. The decline of the euro exchange rate coming on the heels of the drop in the UK pound exchange rate (that started earlier in 2009) helped European exporters reap the benefits of that recovery. Looking forward, after a dramatic recovery in the past 12 months, demand from emerging markets is likely to stabilise or even abate somewhat in the coming year. The boost provided by the weaker euro and pound exchange rates is also most likely behind us. This leads us to expect stabilisation in European export growth that is probably a bit below the first half rate (19% year on year in May.) But foreign trade should remain a significant engine in the current cycle.
The rise in economic activity has started to be reflected in corporate investment in the economies leading the current cycle. In Germany, capacity utilisation in manufacturing rose to 80% in the first quarter of the year from 71% in the middle of last year. Capital spending by German firms rose 1.6% in the first quarter. That trend should continue, in our opinion, on the back of strong foreign demand. For 2010 as a whole, we anticipate investment in machinery and equipment to rise 4% (after a spectacular 20% fall last year), and by 5% in 2011. More generally, as noted above, the non-financial corporate sector has been able to improve its financial position since the beginning of last year.
Meanwhile, a resumption in residential real investment by households is likely to be very gradual, in our opinion, for several reasons. First, housing markets have generally stabilised across Europe in the past six to nine months, but the correction experienced between 2007 and the beginning of 2009 has been insufficient to completely wipe out the excesses of the previous bubble. Price to income ratios remain higher than their long-term average – particularly in the UK and France, meaning that markets remain quite ‘expensive’. Second, bank lending has become much tighter in the past couple of years, especially for first-time buyers: Loan to value ratios have gone down markedly. In the next 18 months, households are not likely to draw down on their savings to invest again in housing markets the way they did prior to 2007.
In total, as economic growth stabilises in the next 18 months, corporations are going to need more capital to invest and households’ savings rates will start coming down from their current highs. But in both cases this is likely to be very gradual, given the uneven nature of the recovery – stronger in the northern part of Europe, much more sluggish in the southern rim, and the uncertainties that will continue to prevail – the fragile pick-up in the US, the stabilisation in world trade, etc. In other words, private savings are not likely to run down quickly unless the current economic recovery gains more momentum sooner than we anticipate. That suggests that yields are likely to normalise only slowly as well.
A Rather Benign Inflation Outlook
The inflation outlook is another reason to expect a very slow normalisation in yields although the prospects look a bit different in the eurozone and in the UK. In the eurozone, headline inflation could accelerate somewhat in the coming quarters, but for specific and rather ‘technical’ reasons. An important part of the rise will be due to one-off factors, such as indirect tax increases in several peripheral countries, administrative price hikes in response to worsening local budgets and recent increases in global food prices. We could therefore see inflation touching the 2% threshold at the beginning of next year. At the same time, there remains a considerable amount of slack in capacity in the manufacturing sector, limiting the pricing power of companies. In addition, the European Central Bank (ECB) has injected a very limited amount of extra liquidities in the economy since it adopted its securities market programme earlier this year. At the time of writing, purchase of securities by the central bank amounted to about €60bn and those injections have been sterilised, meaning that the ECB neutralised their potential effects on money supply. The conditions for a new inflation spiral to take place in the eurozone are therefore not met today, in our opinion, and we expect the ECB to start raising its policy rate, currently set at 1%, only in the second part of next year.
The inflation outlook in the UK looks more complicated. Headline inflation has persistently exceeded the Bank of England (BoE) official target of 2%. Some of the explanation is similar to that of the eurozone (food prices, hike in VAT, etc) but the difference is that the BoE has injected massive amounts of liquidities in the economy through its QE programme, adopted in March 2009. As of August 2010, purchases of gilts amounted to some £200bn and, unlike for the ECB, those injections have not been sterilised. In addition, the weak pound has added pressure on import prices. We therefore expect UK inflation to remain well above the BoE’s target for the rest of this year and in 2011. But given the very tight fiscal policies adopted by the new government, it is likely that the BoE will want to maintain nevertheless a more accommodative stance, keeping its policy rate at its current level (0.5%) through the better part of next year, and keeping an ‘open mind’ regarding additional QE.
Conclusion: Funding Conditions Will Remain Attractive for Some Time
The good news for corporate treasurers from what we just reviewed is that yields are not likely to normalise rapidly. With a slow and uneven recovery in sight, private savings will remain abundant. Central banks will gradually exit their accommodative strategies and inflation is likely to remain a minor concern through next year. If our projections are correct, benchmark 10-year yields should be slightly over 3% in the second part of next year in the eurozone and reach 3.6% in the UK.
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