How the bond market is trading politics
The FT's Thomas Hale and Kenneth Orchard of T Rowe Price explain how the European bond markets are reacting to the political risks arising from the upcoming Dutch, French and Italian elections, as a wave of populist Eurosceptic sentiment sweeps the continent
Produced by Alessia Giustiniano. Filmed by Rod Fitzgerald.
Today, Dutch voters head to the polls. Next month, they'll be followed by voters in France. And we expect elections later this year in Italy and Germany. So what does this mean for the bond markets? Well, I'm joined today by Kenneth Orchard, a fixed-income portfolio manager at T. Rowe Price. So thanks for coming in, Ken. So this first chart we've got on the right here, we can see quite a significant increase in yields so far this year. What's going on?
Well, there have been a few reasons for the rise in yields. Now one is the global reflation theme that's been percolating through markets the last few years. Higher global growth, higher inflation driven by energy prices, a more aggressive Fed, now these are driving up bond yields globally. But another reason is politics. As you mentioned, there are a number of major European elections this year. And following the surprise results in the UK referendum and the US election last year, now the markets are pricing in higher political risk in Europe.
And the next major challenge markets face is today, the Dutch election. What's your view on the impact of a potential upset in the Dutch election and how that would play out in markets?
Well, the markets are quite relaxed about the Dutch election. If you look at Dutch government bond spreads, they're around the same, the mean level they've been for the past few years. I think what's going to be most important for the markets is whether or not the actually outcome, particularly for the PVV party, is close to what the polls are predicting.
If the PVV party were to perform much better than expected, for example, they got more than around 25 seats in the Dutch parliament, well then the market may extrapolate that to France and Italy, as they worry that there has been a systematic bias in the polling that is under-representing populist parties.
Is it fair to say the French and Italian elections are much more substantial risks?
They are greater risks. Our base-case scenario is that Macron wins the presidential elections in France and that we have some sort of continuation of the current fragile coalition in Italy. However, there is a real probability that either La Pen could win the presidential elections, or we could have a euro sceptic coalition in Italy.
In that case, the market's initial reaction would be really sharp risk-off. So that would mean rallies in risk-free bond yields. It would mean wider sovereign and corporate credit spreads and more volatility generally.
And if you're an investor invested in these markets, how could you protect yourself?
Well, the markets' favourite way to hedge this trade or to hedge this risk has been through French and Italian sovereign spreads. French OAT futures and Italian BTP futures are very liquid. They're easy to trade. And that has been the market's focus. However, those sovereign spreads are now quite wide and we think already price in a fair amount of political risk in those countries.
So other ways that investors are looking to hedge their risk are through credit spreads. European credit spreads have not moved very much, and so that can be done using derivatives on credit indices. Flatteners in Germany, the German curve is very steep right now and probably would flatten in a risk-off type scenario. Another way is through FX. So there's things like being long Swedish krona versus the euro or long in the Japanese yen.
And I wanted to just briefly get your view on the Greek situation. Greece was obviously at the forefront of the news several years ago. It's taken a backseat slightly now compared to France, Italy, and the Netherlands. What's going on with Greece? Are markets complacent there?
Well, Greece is much less important than it was because most of the debt is now held by European institutions in the IMF. We anticipate that Greek government will come to an agreement with the European organisations in the IMF some point in the next couple of months because they have limited options available to them.
There is a worst-case scenario where at the last minute they decide to call elections, in which case they may default on their July bond maturity. That would not be a disaster for markets, but it would certainly spook them. And the markets would look to price in higher risk in other peripheral countries.
OK, and very finally, I just wanted to get your view on this. Obviously political risk has helped push bond yields higher this year. But we've also got another big factor, the European Central Bank, which is one of the dominant forces in European markets. I mean, how do we weigh up the influence of the ECB here? Are we under-looking that as well?
The ECB has been a major supporter of fixed-income markets in Europe over the last couple of years. Both negative rates and quantitative easing have pushed down yields across the spectrum. And the ECB is starting to withdraw that next month, as they reduce their QE. The market is also looking towards 2018 and starting to price in a more aggressive ECB.
We're even seeing the pricing of deposit rate hikes earlier in the year. We anticipate that the ECB will actually be much more gradual in withdrawing the stimulus. When you look at the economic data, underlying inflation is very low. Credit growth is limited. So we don't see any real reason why the ECB needs to follow the Fed and quickly tighten monetary policy.
Thanks for coming in, Ken.