Global Daily – Why we continue to see downside for government bond yields

by: Nick Kounis , Jolien van den Ende , Aline Schuiling , Bill Diviney , Joost Beaumont

Global Rates: Central bank purchases, deep recession and disinflation will push down on yields – Following revisions to our base case for the global economy to incorporate a deeper recession and slower recovery (see here) and a wave of government and central bank announcements, we present updated rates forecasts in today’s note (see table below).

We remain of the view that core eurozone bond yields and US Treasury yields will decline. Although the government announcements imply large amounts of extra supply, we think that the impact on yields will be more than offset by central bank purchases, the deep recession and eventual disinflation. US fiscal measures imply around USD 800bn of extra funding. At the eurozone level, we currently estimate around EUR 360bn of extra issuance. This reflects a combination of cyclical deterioration and discretionary fiscal stimulus. These amounts will almost certainly rise. Even more supply is likely on the cards. Having said that, our judgement is that the central banks will do what it takes to stem and reverse the profound tightening of financial conditions. Indeed, after signalling at least USD 700bn of asset purchases initially (USD 500bn of US Treasuries), the Fed has now pledged unlimited asset purchases (see below). Following the announcement of the EUR 120bn additional envelope and EUR 750bn PEPP, the ECB has signalled a willingness to do whatever is necessary, even if this involves raising issuer limits.

Meanwhile, when the crisis fighting is over, both central banks will still be faced with an inflation issue. In particular, the deep recession that we have now entered will over time lead to disinflation. This comes from a starting point – especially in the eurozone – of unacceptably low inflation and inflation expectations. Central banks will need to ease by more for longer in an attempt to get inflation back up over the long term. All this points to significant downside for core yields over the next 3-5 months – with curves flattening – and only a modest rise thereafter.

We expect eurozone country spreads (10y yields versus their German counterparts) to remain elevated over the next 3-5 months. Deteriorating macro expectations, the risk-off environment and increasing supply will put upward pressure on spreads, but we think that the ECB will push hard in the other direction with asset purchases. It can do this using the APP and PEPP, however re-launching the OMT has also become a possibility over recent days. We judge it will do whatever is necessary. Later in our horizon, as growth expectations and risk sentiment turn positive, we expect country spreads to head lower. Finally, we expect asset swap spreads to widen over the next few months. This reflects the combination of ECB asset purchases and risk-off sentiment, both of which should put upward pressure on spreads. (Nick Kounis, Jolien van den Ende, Floortje Merten and Aline Schuiling)

Fed View: ‘Whatever it takes’, but what yield are they targeting? – In its latest unprecedented intervention, the FOMC today announced – in tandem with a host of credit facilities – essentially unlimited asset purchases with the goal to “support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.” This replaces the previous commitment to purchase $700bn in assets. As we discussed last week, the Committee is no doubt unnerved by the backup in bond yields of late, and the latest move is clearly intended to bring yields back down to levels that are supportive of financial conditions. However, without a clear quantitative target on purchases, nor a level in bond yields, the question for market participants must surely be – what level of bond yields is consisted with ‘smooth market functioning’, and the ‘effective transmission of monetary policy’?

In answering this question, we consider two big ‘no-no’s for Fed policymakers: 1) negative rates, and 2) an inverted yield curve. With the fed funds rate already at its effective lower bound, there is little scope for short-end (up to 2y) yields to decline beyond the current 25-30bp level. And if the Fed wishes to keep a positive yield curve, there will have to be some reasonable gap between short- and long-end yields. This suggests 10y yields of around 50bp would both a) provide significant accommodation, and b) avoid the pitfalls of negative short rates and an inverted yield curve. As discussed last week, should large-scale asset purchases by themselves fail to bring yields down, or if the size of purchases become harder to sustain at some point, a viable option for the Fed might be to implement a formal cap on yields. One way or another, though – whether through market forces or central bank intervention – we expect bond yields to remain at these relatively low levels for at least the remainder of the year, regardless of the scale of fiscal stimulus. (Bill Diviney)

ECB View: Eurosystem sharply increased net asset purchases last week – The weekly figures on the Eurosystem’s net asset purchases showed that the central bank markedly increased its purchases under the APP last week. In fact, it tripled net purchases to EUR 17.4bn last week, compared to average weekly net purchases of EUR 5.5bn since the restart of QE in November (and excluding the weeks when it was not buying any assets). The increase does not yet capture any purchases under the EUR 750bn PEPP, but probably does include purchases within the additional QE envelop of EUR 120bn. As such, weekly net purchases are likely to rise strongly in coming weeks as the central bank needs to buy on average EUR 26bn of net asset per week to reach its 2020 QE target. The breakdown of the weekly net bond purchases showed that the PSPP had a share of 75% in total purchases last week, while the CSPP had a share of 12%. The high share of the PSPP was probably related to the sell-off of euro area government bonds last week, with the Eurosystem trying to turn the tide. Still, the average share of the PSPP in total net purchases since the restart of QE in November is 63%, while that of the CSPP is 22%, CBPP3 12% and the ABSPP 3%. (Joost Beaumont)

Global Rates: Central bank purchases, deep recession and disinflation will push down on yields – Following revisions to our base case for the global economy to incorporate a deeper recession and slower recovery (see here) and a wave of government and central bank announcements, we present updated rates forecasts in today’s note (see table below).

We remain of the view that core eurozone bond yields and US Treasury yields will decline. Although the government announcements imply large amounts of extra supply, we think that the impact on yields will be more than offset by central bank purchases, the deep recession and eventual disinflation. US fiscal measures imply around USD 800bn of extra funding. At the eurozone level, we currently estimate around EUR 360bn of extra issuance. This reflects a combination of cyclical deterioration and discretionary fiscal stimulus. These amounts will almost certainly rise. Even more supply is likely on the cards. Having said that, our judgement is that the central banks will do what it takes to stem and reverse the profound tightening of financial conditions. Indeed, after signalling at least USD 700bn of asset purchases initially (USD 500bn of US Treasuries), the Fed has now pledged unlimited asset purchases (see below). Following the announcement of the EUR 120bn additional envelope and EUR 750bn PEPP, the ECB has signalled a willingness to do whatever is necessary, even if this involves raising issuer limits.

Meanwhile, when the crisis fighting is over, both central banks will still be faced with an inflation issue. In particular, the deep recession that we have now entered will over time lead to disinflation. This comes from a starting point – especially in the eurozone – of unacceptably low inflation and inflation expectations. Central banks will need to ease by more for longer in an attempt to get inflation back up over the long term. All this points to significant downside for core yields over the next 3-5 months – with curves flattening – and only a modest rise thereafter.

We expect eurozone country spreads (10y yields versus their German counterparts) to remain elevated over the next 3-5 months. Deteriorating macro expectations, the risk-off environment and increasing supply will put upward pressure on spreads, but we think that the ECB will push hard in the other direction with asset purchases. It can do this using the APP and PEPP, however re-launching the OMT has also become a possibility over recent days. We judge it will do whatever is necessary. Later in our horizon, as growth expectations and risk sentiment turn positive, we expect country spreads to head lower. Finally, we expect asset swap spreads to widen over the next few months. This reflects the combination of ECB asset purchases and risk-off sentiment, both of which should put upward pressure on spreads. (Nick Kounis, Jolien van den Ende, Floortje Merten and Aline Schuiling)

Fed View: ‘Whatever it takes’, but what yield are they targeting? – In its latest unprecedented intervention, the FOMC today announced – in tandem with a host of credit facilities – essentially unlimited asset purchases with the goal to “support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.” This replaces the previous commitment to purchase $700bn in assets. As we discussed last week, the Committee is no doubt unnerved by the backup in bond yields of late, and the latest move is clearly intended to bring yields back down to levels that are supportive of financial conditions. However, without a clear quantitative target on purchases, nor a level in bond yields, the question for market participants must surely be – what level of bond yields is consisted with ‘smooth market functioning’, and the ‘effective transmission of monetary policy’?

In answering this question, we consider two big ‘no-no’s for Fed policymakers: 1) negative rates, and 2) an inverted yield curve. With the fed funds rate already at its effective lower bound, there is little scope for short-end (up to 2y) yields to decline beyond the current 25-30bp level. And if the Fed wishes to keep a positive yield curve, there will have to be some reasonable gap between short- and long-end yields. This suggests 10y yields of around 50bp would both a) provide significant accommodation, and b) avoid the pitfalls of negative short rates and an inverted yield curve. As discussed last week, should large-scale asset purchases by themselves fail to bring yields down, or if the size of purchases become harder to sustain at some point, a viable option for the Fed might be to implement a formal cap on yields. One way or another, though – whether through market forces or central bank intervention – we expect bond yields to remain at these relatively low levels for at least the remainder of the year, regardless of the scale of fiscal stimulus. (Bill Diviney)

ECB View: Eurosystem sharply increased net asset purchases last week – The weekly figures on the Eurosystem’s net asset purchases showed that the central bank markedly increased its purchases under the APP last week. In fact, it tripled net purchases to EUR 17.4bn last week, compared to average weekly net purchases of EUR 5.5bn since the restart of QE in November (and excluding the weeks when it was not buying any assets). The increase does not yet capture any purchases under the EUR 750bn PEPP, but probably does include purchases within the additional QE envelop of EUR 120bn. As such, weekly net purchases are likely to rise strongly in coming weeks as the central bank needs to buy on average EUR 26bn of net asset per week to reach its 2020 QE target. The breakdown of the weekly net bond purchases showed that the PSPP had a share of 75% in total purchases last week, while the CSPP had a share of 12%. The high share of the PSPP was probably related to the sell-off of euro area government bonds last week, with the Eurosystem trying to turn the tide. Still, the average share of the PSPP in total net purchases since the restart of QE in November is 63%, while that of the CSPP is 22%, CBPP3 12% and the ABSPP 3%. (Joost Beaumont)