Macro Weekly – Lucky losers

by: Han de Jong

Big Picture - 27 March 2015 - Lucky losers.pdf ()

There can be little doubt: eurozone government bonds are very expensive. They will get cheaper some day, although that may be quite a while away. Whenever that happens, the holders will suffer losses. Who are they? And do their likely future losses matter to them or the overall economy? This is a bizarre story.
Meanwhile, eurozone economic data continues to surprise positively. Growth is accelerating.

Yield curves on the floor.

Core government bond yields were already very low when ECB President Mario Draghi started hinting at further policy easing by the ECB. Arguably, he did that in the speech he delivered at the Jackson Hole conference in August last year when he argued that inflation expectations had become dangerously unhinged. In the run up to the actual decision to engage in QE, bond yields fell further and the process has continued now that the ECB and the national central banks have started buying. Sovereign spreads have tightened, though credit spreads have not. Government yield curves have really fallen to the floor and a significant part of the curve has actually fallen through the floor: many bonds are trading at negative yields.

One-way risk

As long as the ECB and its friends remain big buyers, it is hard to see yields rising much, and there could well be some further fall in the near term. However, the ECB will not buy forever. So yields will rise at some stage. There would be something seriously wrong if they don’t. How will markets behave when yields start to move higher? My guess is that it will be different from the trough in previous cycles. During all previous cycles the low of the cycle could only be recognised with hindsight. Even at the trough in yields during these cycles, the bond market must have felt like a two-way risk. That is different now. With the yield curve in many countries close to zero, the longer-term upside for yields is much larger than the downside. When a market poses a one-sided risk all participants want to move in the same direction. I think that one of the biggest risks in markets these days is that there will be no buyers of government bonds when yields start to rise. People will talk about a lack of liquidity, but liquidity support will not do anything for the market as there will simply be a lack of buyers. Market movements could become quite volatile.

Who will lose?

When bond markets turn, they might turn aggressively. I don’t think that moment is near but logic suggests it will come and it is better to have thought about it beforehand. Holders of bonds are set to suffer losses, potentially large ones when that happens. What will happen to them? Perhaps a better question is, who are they?

I often ask investors if they own bonds with negative yields. Most investors I talk to are private investors and very few seem to own these bonds. So it seems that it is mainly institutional investors holding these bonds. Before too long, the ECB will also be a significant holder.

Will institutional investors panic when yields move higher and they start suffering losses? I actually don’t think so. Insurance companies and pension funds own bonds partly to earn an income (which is not going to work for negative-yielding bonds, I think), but also to ‘protect against a further decline in interest rates’, even though the latter seems hardly possible from current levels. A drop in interest rates blows up the net present value of their liabilities. A rise in interest rates does the opposite. In recent years, pension funds and insurance companies have achieved excellent investment returns, yet they have seen their liabilities grow even faster. In the years ahead, we will probably see the opposite. The (Dutch) pension funds will lose billions of euro, but, bizarrely, they will open champagne bottles when interest rates rise. My guess is that they will want to sell some positions, but not aggressively, as they need a diversified portfolio. Also, the decline of their liabilities will prevent them from having to sell other assets to cover the losses on their bonds. That is why I would guess that other asset markets will likely be OK when interest rates start rising.

All this will not happen anytime soon, so we have plenty of time to think about it a little more.

Another market participant likely to lose money is the ECB. When the Fed started its first QE programme towards the end of 2008, the yield on the 10-year US Treasury bond was around 4%. The ECB, on the other hand, is buying bonds at yields near zero. I am not sure about the accounting rules the ECB applies, but should they value their bond holdings on a mark-to-market basis, they are likely to suffer losses as well. This may attract public attention and lead to outrage. In response, politicians may try to reduce the ECB’s independence. The fact of the matter is that it does not really matter. A central bank is not a ‘normal’ company. It can easily operate with negative equity. So my guess is the ECB is not going to be too concerned about suffering losses, though they will undoubtedly try to prevent that.

On balance then, we have identified insurance companies, pension funds and the ECB as important and (at some stage) large holders of government bonds. And yet, for different reasons, none of them are going to be stressed out by losing money on their bond holdings. So, they are ‘lucky losers’.

Last week’s data

Last week’s data confirmed recent trends. US data continues to be soft, raising further questions about the positive view most analysts take on the US economy. An exception was the preliminary Markit PMI which rose a touch both in the manufacturing sector and in services in March, suggesting our ‘temporary-weakness’ hypothesis could be correct. But we need to see an improvement in the data soon. Adverse weather and the strikes in the ports on the west coast are among the temporary factors limiting growth. These things are now behind us. If the data on the economy do not start to pick up from here, there is another problem. The Markit PMI data just mentioned is perhaps an early sign that activity is picking up.
Also consistent with recent trends, eurozone economic data improved further and beat expectations. In fact, the eurozone data is starting to look rather strong. The authoritative German Ifo index of business confidence, for example, improved to a greater extent in March than expected. Business confidence for the eurozone as a whole, as measured by the PMI was also stronger than expected in March. Consumer confidence in the eurozone also rose much more strongly than was expected. Last, but not least, money and credit data are turning up. M3 growth accelerated to 4.0% yoy in February, while M1 growth amounted to 9.5% yoy. The credit data are starting to show an improvement also. They are by no means strong, but the trend is clearly up.