QE and improving indicators trigger rout for Bunds

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Christophe Donay, head of Asset Allocation and Macro Research at Pictet Wealth Management analyses the turbulences in the German fixed income markets. 

The defining characteristic of the global economy over the past couple of years has been desynchronisation, in economic cycles and in policy responses. The resultant uncertainty has driven down yields on developed-economy sovereign bonds. But, by coincidence, the major economies will be temporarily aligned over the next few months, as growth and headline inflation pick up globally. This is putting upwards pressure on long-term interest rates, and triggering tactical moves in bonds. Current conditions point to a shift out of large positions in US Treasuries and German Bunds (although these assets will remain important for portfolio protection), with emerging market local-currency debt one possible beneficiary.

Economic growth is set to improve in the coming months across major economies. The US should bounce back from a weather-affected Q1, the euro area continues its slow recovery, and leading indicators in many emerging markets are picking up. Inflation will also rise globally, in the wake of the surge in oil prices in recent weeks to approaching USD70 per barrel.

Treasury and Bund yields rise

Real economic growth and inflation are the main risk factors that drive sovereign long-term interest rates. Their rise will push up 10-year US Treasury yields, probably to around 2.5%. US Treasuries have been in strong demand as investors look to diversify portfolios against the risk of an equity market shock. Given their negative correlation with equities, they are likely to remain so. But in the short term, substantial outflows are occurring.

Meanwhile, in the euro area, the conjunction of ECB QE with signs of economic improvement is driving up German Bund yields. Intuitively, QE ought to depress yields on sovereign bonds. But the US experience shows that, in practice, when central bank QE and an improvement in leading indicators coincide, sovereign bond yields temporarily spike: this happened during each of the three rounds of Fed QE (see chart), and can now be seen again in the euro area.

EM local-currency debt could benefit

One beneficiary could be EM local-currency debt. Yields are highly attractive (at around 7% for the JPMorgan GBI-EM). Until recently, this was outweighed by currency risk. But following large adjustments, we estimate that EM currencies are now heavily undervalued against the US dollar.

“A lot of bad news is already priced into EM currency valuations. That includes the tightening of Fed monetary policy, assuming it proves to be gradual – and indeed it may be even more gradual than markets expect. The large undervaluation of EM currencies suggests that there is potential for a rebound.

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