Q€ Starts Today, the Bond Bubble Started Yesterday

Economic analysis by Filipe R. Costa

No one in 2012 could have estimated with precision the extension of Mario Draghi’s pledge to do “whatever it takes” to save the euro. At that time, the comment was welcomed by the markets and helped to put a cap on peripheral bond yields. But more than anything, it started a new era for the ECB, extending the limits of its action far beyond what many would think possible. Since that time, the ECB has rolled out a series of unconventional measures to prevent chaos in the European sovereign market, to re-inflate the dormant Eurozone economy, and to counter-balance fiscal austerity.

Draghi has always filled his speeches with a persuasive tone and he has been able to slowly introduce all the unconventional monetary tools Germany always opposed. No matter how fiercely Germany has been opposing such measures, the truth is that Draghi has been able to push for whatever he wants, to which the current asset purchase programme is ample testament. Today, history is being made, as the ECB starts its 1.1 trillion euro asset purchase programme.

Announced just a few weeks ago (but already in the spotlight since last year), the European quantitative easing programme, or Q€, will mainly target sovereign debt, will occur at a 60 billion euro monthly rate, and will be more or less open-ended for the ECB to effectively pursue its main inflation target of 2%. At the last ECB press conference, Draghi gave some extra details on the programme, preparing for the possibility of its being extended and stating that the central bank is going to buy sovereign debt even at negative yields, meaning it will have to pay governments to loan them funds. However, Draghi put a limit on the negative yields the ECB is willing to take in his statement that the ECB won’t buy bonds with negative yields surpassing the -0.2% set for the deposit facility. This last pledge is more or less irrelevant, as arbitrageurs would play out yields that were more negative than the deposit facility. If the yields on a bond were -0.3% for example, an arbitrage opportunity would set in, as banks could sell the bonds, receive a yield of 0.3% and then park the funds at the central bank at a rate of -0.2%, for a risk-free yield gain of 0.1%.

So no matter what Draghi says, bond yields have a floor of -0.2%, corresponding to the current deposit facility rate (at least those with short maturities). At the same time, the large scale QE programme and the limited availability of sovereign bonds will very likely lead to a flattening of yields, both across countries and across maturities, with all of them more or less converging to that single number. This is already happening, with German bund yields now at -0.2% for all maturities up to 2 years.

In contrast to the US experience – where Ben Bernanke moved relatively fast, first injecting liquidity to avoid a systemic failure and then boosting growth through asset purchases – in Europe everything moved in slow motion. Whether it was the best option or not, at least QE in the US was launched at the right time to prevent deflation and economic collapse. In Europe the first concern was not with the Eurozone economy but rather with very specific interests in France and Germany where banks would have failed if Greece had collapsed. Decisions were made to benefit these banks at the expense of the population, which was further punished with fiscal tightness. At that time, bond-buying could have made sense, as yields on peripheral bonds were too high and distorted by the speculative idea that the ECB and European institutions could allow the euro to collapse. The ECB should have never allowed the market to exploit such an idea. Purchasing bonds with inflated yields would then be a way of telling the market it was wrong and would have allowed the peripheral countries to reduce financing costs that were wrongly formed in the market.

It was only much later that Draghi came to the rescue with a pledge to adopt measures to prevent the collapse of the euro. It helped reduce the yields but came too late to avoid years of unnecessary pain that led to a very harsh recession. Now, Draghi has the much more difficult task of reversing years of failed fiscal policy which has culminated with persistently high debt-to-GDP ratios, negative growth rates, huge unemployment rates, and the prospect of a deflationary spiral. Europe is now in a much worse shape than it was a few years ago and QE may not be enough to solve the problem.

While Europe remains submerged, the US economy has resurfaced. The US unemployment rate is now at 5.5% and non-farm payrolls are steadily increasing above 200k per month. Six years after bottoming out, the US is now thinking about the first rate hike. Meanwhile, Europe is heading in the opposite direction, having just introduced QE and cut interest rates to negative territory. The Euro plunged from an all-time high against the dollar of 1.60 in 2008 to the current 1.0880 level not seen since 2003.

Many are bullish on the euro, as they believe QE is already fully priced. My view goes in the opposite direction. Europe is desperately experimenting with monetary policy, having already surpassed the academic barrier of negative interest rates without knowing how badly it can end. At the same time, why the optimism for QE when all previous measures aimed at enhancing credit availability have failed? What is going to change sufficiently for banks to start lending? The ECB will have to do much more and will further impart euro weakness. And let’s not forget about the period of political instability to come, with many general elections set to occur this year, particularly in peripheral countries. I still believe a rate hike in the US is not fully priced in, both in terms of the timing and its extent. With economic improvement setting in, the Fed may add more than just 25 basis points in a one-year time window, which would further boost the dollar against the euro. So I am very pessimistic about the euro for the rest of the year, favouring the US dollar and the British pound.

While espousing a pessimistic view on the euro, I hold an even more pessimistic view on QE. Europe is not a unified territory with a central bond issuer. Each country issues its own debt, meaning the risk varies from one country to another. If on one hand, allowing yields to hit speculative levels (as I mentioned above) is not desirable, then by the same token, a complete flattening of these yields is not desirable either, as it corresponds to a complete disregard for risk profiles. The yield on a German bond should be lower than the yield on a Spanish bond to reflect the different levels of risk. The desperate hunt for yield, at a time when the ECB is to start buying sovereign bonds, will flatten yields and create the worst bond bubble ever.

It all starts with short-term core country yields, which will converge to the deposit facility rate as investors demand them. Then, investors will look for these safer bonds but at longer maturities. In the next stage, investors will look for higher risk countries inside the Eurozone. In the end, we won’t notice much difference across maturities and countries, as if the Eurozone were a unified market.

The first signs of a bubble are already present: 1) Bond yields for Germany are relatively flat across maturities, with a 6M yield now at -0.208% while a 20Y yield is at +0.744%. 2) The spread over German bunds is decreasing for almost all countries. Investors perceive the higher yields offered by Portuguese and Spanish debt as a riskless profit opportunity rather than as a compensation for the additional risk taken. The spread over a German bund for a Spanish 10Y bond is around 0.931%, which is very low given the fundamentals behind both countries. 3) If the 2% inflation goal the ECB pursues is to be seriously taken, then the current yield on a 20Y German bond, currently at +0.744%, looks preposterous. Investors are pricing inflation to be much less than 2% for the foreseeable future, and not only over the short term.

An epic bond bubble is forming and we will pay for it in the future. But fighting the ECB is never a good option, so shorting bonds is out of the question; that said, keeping them isn’t exactly the best trade either, as prices are artificially skewed by the central bank intervention. So now is the time to sit back, hold onto your cash and enjoy the deflationary spell. After all, it isn’t that bad to be able to buy the same things with less money, is it?