Bonds, inflation and the eurozone economy

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Investors have sought out bonds as a safe haven during the recent spate of volatilitiy on equities markets in a move to control risk.

But as stock indices start to rebound amid a growing feeling that markets are nearing the end of the credit crisis, what are the prospects for European bond yields?

Are yields fully reflecting the prospects for the eurozone economy and what impact has the strong euro had here?

If bonds retain their popularity which part of the market offers the best value?

Elwin de Groot, senior market economist at Rabobank, answers your questions below.


Can we expect investment bankers to regain their lost confidence caused by the recent crisis in financial markets, and what will happen to bond yields if equities continue to recover?
Augustin Dufatanye, Reykjavik

Elwin de Groot: In terms of market sentiment, the worst may already be behind us. The good news is that while financial institutions have written down considerable sums again over the first quarter, they have also been more active lately in raising capital to strengthen their balance sheets. The relative ease with which institutions have been able to do so is encouraging.

However, we are not there yet, and in other areas, such as transparency in exposures and the valuation and rating of complex financial instruments, more needs to be done. Moreover, we shouldn’t overlook the long-term effects of this crisis, which are likely to lead to a prolonged period of higher risk premiums in the market. The rebuilding of confidence will be a time-consuming process, as financial institutions have learnt the hard way how important liquidity is. For one thing, liquidity provision in the real economy is likely to be less abundant than before the crisis.

This brings me to the second part of your question. Assuming a recovery in the stock market is the result of increasing risk-tolerance among investors, we are likely to see a further rise in bond yields indeed. I am cautious, however, about the general stock market outlook, this as profit fundamentals are likely to weaken due to slowing global demand growth and increasing costs pressures from raw materials and wages.


As a pensioner over 85 I need to invest in secure bonds to produce income and if possible a protection against inflation. Can you please give a list of bonds which can achieve this end.
S Davis, London

Elwin de Groot: I am afraid I cannot give you any specific and bespoke investment advice, because I would have to take into account all factors that are relevant in your personal situation. Regulatory rules are very strict these days!

As a general rule, the further one gets on the age-ladder (and I consider you are well-advanced, congratulations!), the less risk one can afford if certain returns are to be met. Moreover, the shorter the maturity of the investment, the lower the interest rate risk.

Investors looking for inflation protection have a number of options. Firstly, they could buy inflation-protected government bonds. These are certainly available in the UK, which has been one of the frontrunners in the area. Secondly, an increasing number of banks have been issuing inflation-protected securities targeted at the retail market. I recommend you ask your broker about the specifics of these securities.


The emerging markets bank bonds have been hit quite hard in the recent turmoil. Kazakh banks are trading at high spreads, Russian and Eastern European bank spreads also seem to indicate that they are in deep trouble. Is that so, or is there value there?
Pascal Crepin, Singapore

Elwin de Groot: The subprime crisis is not the real issue here and asset prices in particular markets may have been pushed to levels that are no longer consistent with fair value. However, to the extent that the subprime crisis has been the result of an underestimation of risk in previous years (and this may have been a factor at play in many other countries, also in Central and Eastern Europe), it does explain why the decline in risk aversion has hit so many markets and why emerging market spreads have widened significantly. Growth of credit supply in some Central and Eastern European countries in recent years looks rather unhealthy and unsustainable. This certainly raises concerns about the credit quality.


Is the recent move up in yields on both sides of the Atlantic just a safe haven unwind or is it also a sign that the Fed, Band of England and European Central Bank are now all on hold? Will they stay on hold even if economic data continues to deteriorate and will yield continue to edge higher?
Chris Quin, Haslemere

Elwin de Groot: The recent move up in yields is clearly connected with the unwinding of safe-haven trades, a point that is also illustrated by the recent depreciation of the yen against the dollar. I suspect the impact of safe-haven demand on global bond yields has been considerable since the onset of the financial markets crisis. You are right to point out that the recent statement by the Fed as well as “hawkish” comments by central bankers on this side of the Atlantic have contributed to higher yields, particularly at the short-end of the curve. Both factors have led to a significant flattening of the yield curve over the last couple of months.

Our base scenario is that economic data will continue to deteriorate this year, which would eventually lead to a moderate easing by the ECB. The Fed, in contrast, has largely exhausted its policy options and there is a good chance they will actually have to tighten policy as we approach year-end. So, first of all we expect European bonds to outperform US bonds on a six to twelve month horizon. Secondly, we expect the US yield curve to flatten, but the European yield curve to steepen. At the long-end of the curve we also expect to see upward pressures on yields due to rising term premiums reflecting increased inflation risks.


Do rising bond prices affect the currencies markets – what happens to currencies when bond prices fall? What is the best way for investors to exploit the correlation?
Nitin Khanna, Birmingham

Elwin de Groot: Generally speaking, rising bond prices coincide with a depreciating currency. If bond prices rise because markets expect real interest rates (or real yields) to fall vis-à-vis other countries, the home currency tends to decline. The past two years have clearly demonstrated the phenomenon described above. Whereas European bond yields have remained virtually unchanged between mid-2006 and March 2008, US yields have dropped sharply, on the back of a weakening growth outlook and the Federal Reserve’s aggressive interest rate cutting. Alongside, the dollar has slumped by nearly 20 per cent against the euro.

I do have to add a warning here, because the correlation between euro-dollar and bond yield differentials has been entirely the opposite in the period 2003-2006. Nevertheless, we can exploit their general co-movement if we combine the finding above with another finding from empirical research that comes from the test of uncovered interest parity theory. This theory stipulates that, because of arbitrage, the currency of a country with the highest risk free interest rate should depreciate against the currency of a country with a lower risk free interest rate.

Empirical research, however, does not find convincing evidence of this theory. In fact, in quite a number of cases the research finds that investing in the highest yielding currency offers excess returns, which explains the recent popularity of carry trades. Now, if you consider that real yields tend to move towards each other in the long-run, this would imply that by investing in a bond of a higher yielding currency, a potential drop in its yield and hence a positive price return would (partly) compensate for a weaker currency.


In view of the appreciable increase in global inflation, is it advisable for a conservative investor to switch to a combination of linked bonds and a minority holding of index funds in major stock markets?
Selwyn Denan Israel

Elwin de Groot: Inflation-linked securities are arguably the best and most direct instruments to protect against inflation rather than commodities, precious metals, or equities. Although there is a common belief that equities provide a natural inflation hedge, this only holds in the case of a demand-driven inflation shock rather than a supply-driven shock, such as in the 1970s and 1980s. After all, rising demand would allow firms to raise their prices and profit margins, but falling demand would not. My feeling is that the latest oil price surge has some characteristics that would rank it closer to that of a supply- rather than a demand-shock. Go figure!


Do you feel that the AAA-rated Danish mortgage bond market (which has not seen a default in over 200 years) has important lessons for the rest of Europe?
Nichola Marshall, Essex

Elwin de Groot: Whether defaults occur and to what extent will depend on many factors, such as the structure of the housing market, the way mortgages are financed. As the subprime crisis in the US has demonstrated, financial innovation, such as securitization, may lead to an under-estimation of risk if this process fuels irresponsible behaviour.

Having said that, the Danish model may have some interesting characteristics that would help avoiding at least one particular problem that has been laid bare by the financial markets crisis, namely the lack of liquidity and the problems this has caused for the banks.

Because Danish mortgage lenders are forced by law to sell the loans they originate as bonds to investors, this implies that these instruments don’t get stuck on their balance sheets. Moreover, because these bonds have long maturities, there isn’t a maturity mismatch either. The maturity mismatch of Structured Investment Vehicles has relied on the assumption of a liquid money/corporate paper market, an assumption that has been proved wrong. Another feature of the Danish system is that it has a built-in safety buffer, because the maximum loan-to-value is set at 80 per cent.


Why has the yield curve not taken off at the long end given the inflationary policies being pursued by the US, in particular, but also the ECB? And why have interest rate curves not already risen markedly?
JBD

Elwin de Groot: That’s an interesting question. I see two explanations as to why the yield curve has not taken off at the long end. The first is that government bonds (US and German bonds in particular) have acted as a safe-haven in the current financial markets crisis, which has depressed yields. Their liquidity has proved an important characteristic of these assets.

Another explanation is that the sharp rise in oil prices in recent years has led to a massive redistribution of wealth from oil consuming to oil producing countries. Because oil producing countries have been unable to keep up with rising oil prices in terms of their domestic spending and some countries have pegged their currencies to the dollar, they have re-invested a sizeable amount of these funds in bonds. The negative correlation between the change in global bond yields and oil prices in recent years is actually quite stunning.

I do not agree with the notion that the ECB is pursuing an inflationary policy. As for the eurozone, I think that current rates are more than sufficient to keep underlying domestic prices pressures in check, as the economy slows down this year. The main reasons behind the current high inflation rate (oil and food prices) are outside the ECB’s control. The economy is not overheated (a big difference compared to the early seventies when the first oil price shock occurred). A look at the evolution of consumer spending since the expansion began is quite instructive.

Arguably, the Fed has been rather aggressive and one may question whether their policy will do more harm than good, indeed. Although long-term yields have risen in recent months, there is still an overarching belief in the market that the recent bout of inflation will prove temporary and that central banks will be able to steer clear of the runaway inflation scenario.

I think that inflation risks and increased market volatility and uncertainty about future interest rates warrant higher term premiums than the market is currently pricing in. So in that sense I share your concern and I expect to see higher long-term rates in the medium-term, particularly in the US.


Where do you see the eurozone 10year-30year spread in 6 months time?
Jens Hoiberg-Nielsen

Elwin de Groot: I see the 10-30 spread narrowing from around 50bp at present to around 30bp in 6-months time, as it has overshot our medium-term target. I have three reasons. Firstly, as liquidity premiums ease, this is likely to have a bigger impact on the 10y yield (upward pressure) than on the 30y yield. The second reason is that I expect to see some further spill-over effect from rising inflation on medium-term inflation expectations, whereas long-term inflation expectations should remain anchored. Finally, in my opinion the 10-30 spread has already widened to a point where it is reflecting a significant deterioration in the growth outlook.


What signs are there in the eurozone indicating that we are nearing end of the credit crisis? and how can smaller investors take part in credit swaps?
Ravi

Elwin de Groot: Signs in the eurozone that the credit crisis is nearing its end are visible in the derivatives markets. Widely followed indicators, such as the European iTraxx indices, which track the cost of insuring against credit defaults, have improved significantly since the Bear Stearns rescue, as confidence has strengthened that an all-out systemic crisis will not occur.

However, I doubt whether we are truly nearing the end of the credit crisis. There is still considerable dislocation in the money markets. In the first quarter of this year, there were signs that an unhealthy vicious circle of deleveraging by financial institutions (including hedge funds) and falling asset prices was developing, which led to extremely difficult market conditions. This was reflected in the derivatives markets in particular. Over the last two months, market conditions have improved. But the recent fall in credit default swaps is merely a ‘normalization’ following a period of intense uncertainty. So we have once again arrived at a point where fundamentals should take over.

I expect to see more economic weakness in the eurozone in coming quarters, which may have an impact on credit quality. So while we may have seen the worst in terms of market sentiment, the full knock-on effects of the credit crisis are still to be felt.

For smaller investors, the possibilities to take part in credit swaps (or credit default swaps) are relatively limited, as this area of the market is largely confined to the professional business. However, smaller investors could take part by trading futures on the aforementioned indices (rather than in individual names), or, in some cases, buy tracker funds on these indices. This is of course under the proviso that your broker offers these services.


With the announcement by Saudi Arabia that they are going to increase oil output, what positive impact will the markets take from it? Will it release more cash into market? Henber Thomas India

Elwin de Groot: Although I don’t consider myself an oil specialist, my feeling is that the announcement by Saudi Arabia to increase oil output by 300,000 barrels a day is not material enough to have a huge impact in the short-term. I am still a bit surprised by the way the global economy has been able to digest soaring energy prices since 2003, but the key here is that the upward trajectory in oil prices has been largely demand-driven.

However, I doubt whether the global economy will be able to cope equally well with the recent surge in prices, as it appears to be driven by other factors as well. Oil prices at $125 a barrel could prove a serious problem for global growth this year and next. Central banks in overheated economies may have to move aggressively.


Considering the prize and yield today, would you recomend buying euro-bonds now? If yes from which nationality?
P. Fischer Luxembourg

Elwin de Groot: In absolute value terms we need to take into account the possibility of a further rise in yields. Indeed, I see the long-term fair value of European 10-year yields at around 4.7 per cent. That is around 50 basis points higher than they are at present.

In relative value terms I consider Eurobonds as having more value than their US counterparts. Typically, the short-maturities may offer the best value, given the relative flatness of the curve.

To an investor not constrained by liquidity issues, I believe non-German bonds may still offer some value, even though their spread over German bunds has narrowed significantly since March. I would have a slight preference for the Belgian and Italian issues.


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