- Government bonds rally globally, with the Bund yield falling to a record low
- Economic recovery, turn in inflation and re-calibration of policy expectations should lift yields
- US consumer confidence surges as labour market recovery gains pace
Government bond rally driven by adjustment in short rate and inflation expectations…
Government bonds continued to rally in most major markets on Tuesday. The declines in government bond yields were particularly marked for core eurozone bonds, with German Bund yields falling to a new record low. This takes the fall since the start of this year to around 80bp. The fall in yields reflects a number of factors. There has been a shift in monetary policy expectations. Financial markets increasingly started to price in that short-term interest rates would remain low for an extended period following the actions and communication from the ECB. For instance, at the start of the year, financial markets expected the 3m Euribor rate to end 2015 at 0.75%. By early June, this expectation had been adjusted sharply downwards to around 0.25%. In more recent weeks, markets have been downwardly revising rate expectations for 2016-2017 as well. The central bank’s increasingly aggressive forward guidance reflects its fight against undesirably low inflation. Inflation has drifted lower than it and financial markets expected. As a result, investors also adjusted their expectations of inflation over the next few years downwards.
…as well as QE and safe haven demand
Another key factor driving yields lower has been rising expectations of large scale asset purchases by the ECB. Such a programme would likely need to be based on government bond purchases, and therefore such speculation has likely been supportive. The idea stems from the central bank’s signal that this is an option on the table in case of further downward surprises in inflation or a weaker than expected economic recovery. Furthermore, the escalation of geopolitical risks may have also led to some safe haven demand, though evidence on this front has been mixed, as there have been few other indications of a deterioration of investor sentiment. A final factor to bear in mind is that the government bond markets look to be extremely thin, with liquidity low, partly reflecting the holiday period. This means that the bond rally may not be driven by the kind of investor conviction that might be implied by record low Bund yields.
Yields to stay low near term, but we see rises further out
The factors that have supported the bond market look set to persist near term. However, we expect government bond yields to rise later in the year and in 2015. We expect the global and eurozone economic recovery to gain pace, while inflation is likely close to an inflection point. Against this background, we expect markets to price out the possibility of QE from the ECB. In addition, we think expectations of Fed rate hikes for 2015 will start to build, which should lead to a fall in EUR/USD. This will further remove pressure from the ECB to act as it will create an inflationary impulse.
US consumer confidence surges
A look at the bond market might make one forget that there is a recovery going on. The Conference Board’s measure of US consumer confidence surged to 90.9 in July, from 86.4 in June. The outcome took the series to the highest level since October 2007. The outlook for consumption is steadily improving on the back of wealth gains and an accelerating labour market recovery. Indeed, the labor differential index, which measures the amount of consumers that think that jobs are plentiful minus those that think that jobs are hard to get, and which moves in tandem with the unemployment rate, rose to -14.8 in July, up from -16.1 the month before. This was the highest level since June 2008 and a clear indication that the improvement in the labour market is lifting the mood of consumers at the moment.