Interest rates in the Eurozone have reached extraordinary low levels. The highly unusual phenomenon of negative bond yields is now common. For example, the 5 year German bunds have been offering a coupon rate below zero. This situation is intensifying the search for income and consequently driving down yields. Investors, including ourselves, bought European corporate bonds in late 2014 in the belief that the start of the ECB €60bn monthly bond purchasing programme in January would eat up bond supply in Europe leading to scarcity and rising values. The situation was suddenly changed when the ECB QE programme reversed the deflationary pressures in the Eurozone far sooner than expected. The new expectations of inflation forced European bond issuers to respond to the change by offering more attractive higher yields. With rising bond yields come a corresponding fall in bond prices. We have therefore witnessed the early but significant signs of distress in European sovereign bonds.
Britain is still borrowing heavily and servicing an ever-growing debt pile. If the UK gilt market starts to spike, with yields forced to rise as investors demand higher returns to combat eventual inflation and interest rate rises, this could seriously hit the cost of borrowing and impact the economic recovery.
Prior to the election, the 10 year Treasury Gilt gross redemption yields stood at just under 1.9%. Two weeks later, they broke above 2% for the first time in six months with bond values subsequently falling. This was partly due to the recent rebound in oil prices fuelling inflationary expectations, together with a broad sell-off of Eurozone bonds.
Foreign investors have been selling their UK bonds. Non-residents sold a total of £14bn between January and February. This is part of a wider trend as prices of Western sovereign debt have been inflated by printed money, causing a bond bubble that could burst with inflation and interest rate rises. This is why some bond investors have been leaving the market ahead of a potential loss occurring exit and explains why the European bond market has witnessed significant rises and falls recently.
The threat of rising bond yields will have a major impact on western governments not least in the UK. Our public finances remain fragile with borrowing of £87bn in 2014/15 and a national debt of £1.5tr, which nearly doubled over the term of the last parliament. Financing the rising cost of this debt will be challenging.
‘After a miserable 2014, the Eurozone is growing’
After a miserable 2014, the Eurozone is growing. European data has been improving prompting economists to review upwards their growth forecasts. The ECB QE monetary stimulus, lower energy prices and improved bank lending levels have already created inflationary pressure. A big turning point for Europe was the end of the European banking asset quality review. European banks have been under pressure to improve Tier 1 capital ratios. By shoring up capital reserves they cut back on lending to the economy. Now, European banks have been given the all clear and therefore have resumed normal lending and are competing for new business which is leading to falling commercial lending rates.
The combination of better lending conditions, lower oil prices, and the depreciation of the Euro by 8% since January has increased European output and exports.
Retail sales and new car registrations rose at a healthy pace suggesting that energy related savings are being spent not saved. With employment rising and wage growth picking up, we expect further solid spending growth this year and next. Lower borrowing costs will also encourage business investment. It is expected that Eurozone GDP will grow 1.6% in 2015 and 1.8% in 2016. In fact, Europe may be in better shape than is reflected by current markets as monetary policy takes time to filter through into the real economy. After three years of policy easing and now full QE, Europe may well see stronger economic growth and higher inflation than may be currently expected.
Deflationary fears have moved to inflation expectations, credit is flowing more freely and demand from households and companies are on the rise. Consumer confidence is strong despite concerns over Greece.
Over the past five years European company earnings have lagged behind those of the US as America’s growth has powered ahead. This is starting to change which bodes well for European equities. Perhaps the most dramatic transformation is that of the Spanish economy. Recent headlines have been about bailouts, crushing unemployment, high bond yields and bank crisis. Now, it is a growing economy with 2.6% GDP growth this year. Spain will grow almost as fast as the UK and a lot faster than France or Germany. Unemployment, thankfully, is starting to fall as manufacturing and exports are up. There is also good news in Italy. The Eurozone’s third largest economy is benefiting from the ECB stimulus package, falling oil prices, and at last the easing of austerity measures. The Italians can expect 0.7% growth this year.