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Yields persistently low in the developed countries

The essential

Yields in the developed countries fell sharply in 2014, confounding all analysts’ forecasts.

Many obstacles remain that will hinder a rapid rise in long-term yields in the developed countries in 2015. Yields are likely to stagnate in the eurozone and Japan and see only a modest rise in the United States and United Kingdom.

 

Developed market yields fell sharply in 2014

Contrary to the forecasts of nearly all analysts, long-term yields fell across all developed countries in 2014. Their rise had been prevented by numerous factors. First of all, US growth fell significantly short of expectations from the beginning of 2014. At the same time, the world saw several geopolitical conflicts  (Ukraine and Russia, the Gaza Strip and Israel, Libya, Syria and Iraq), fuelling the search for safe havens. Furthermore, the expectation that Fed tapering (the $10 billion reduction in monthly asset purchases at each FOMC meeting) would put upward pressure on US long-term yields—and developed countries’ long-term yields generally—failed to materialise as China accelerated its purchase of Treasuries at the same time and in similar proportions. The rise of deflationary risk in Europe also weighed on long-term yields. However, while long-term yields clearly fell, yields rose on the short end (two to five years) in the United States and United Kingdom with the cyclical improvement of the labour market and prospects of rising key rates in 2015. As we will see, the obstacles to a rise in long-term yields have not disappeared.

The slow speed and weakness of the Fed Funds tightening cycle will limit the rise of long-term US yields

The cycle of rising Fed Funds rates will be slow—slower than suggested by the projections of the members of the Fed (the “dots”)—because the conditions on the labour market are structurally less favourable than in previous cycles (see “FOMC: The Inevitable Reconciliation of Doves and Hawks”, October 2014).

We are now up against the fact that it is very difficult for the United States to experience alone a cyclical improvement and to envision a cycle of monetary tightening. Because the Fed has envisioned a normalisation of its monetary policy just as several other major central banks have taken the path toward monetary easing, the US dollar has been on a rapid upward trend since the summer of 2014. Even if the US dollar is not currently very strong on its own (the actual real exchange rate is still more than 10% lower than its long-term average), its rise, which coincides with a drop in the price of commodities, has further restricted the outlook for US inflation. And despite undeniable cyclical improvements on the UK and US labour markets, wage inflation is nowhere to be found: real wages continue to stagnate, standing in the way of a hasty acceleration of inflation.

Finally, the Fed itself has noted that US potential growth was significantly weaker than previously, downgrading its long-term growth forecast five consecutive times (2.1% in September). The weakness and slow seed of the Fed’s next monetary tightening cycle will limit the rise of long-term yields, which depend in theory on the behaviour of actual future short-term yields.

Liquidity will remain abundant on the global level

While the Fed ended its QE policy in October, one should not overlook the fact that the three other big central banks (as measured by the size of their balance sheets)—the People’s Bank of China, the ECB and the Bank of Japan—will continue to expand their balance sheets over 2015 if not longer, meaning that liquidity will continue to grow rapidly on the global level. This will continue to weigh on the long-term yields of the developed countries. On every occasion in recent years when central banks rapidly expanded their balance sheets, widespread bearish momentum exerted itself on the long-term yields of the developed markets (see Chart).

European yields will remain historically low

The ECB, aware that inflation expectations did not materialise (as measured by market variables and consumer surveys), beefed up its policy around mid-2015 with negative deposit facility rates, TLTROs and asset purchase plans. The objective of the ECB is to expand its balance sheet to early-2012 levels, that is, to approximately €3 trillion compared to €2 trillion today. Despite these measures, the five-year/five-year inflation swap rate, which Mario Draghi said at Jackson Hole was the medium-term inflation expectation indicator tracked by the ECB, accelerated its decline in October 2014. The ECB is likely to go even further and adopt a policy of buying sovereign bonds, which would keep the long-term yields of the eurozone’s core well below their equilibrium value, which is in itself weak (approximately 1.60% for the German 10-year yield).

Germany’s yield curve is now very similar to that of Japan. It is now clear that the ECB will maintain a zero interest rate policy for years to come, just like the Bank of Japan and the Swiss National Bank. Germany’s yield curve will remain flat and close to zero on the short end and could even flatten further on the 5-to-10 year segment if inflation continues to disappoint. We can legitimately raise the question of net purchases by non-Europeans; aside from diversification, there is much less interest in acquiring bonds for which yields are very weak and which are denominated in a currency fated for depreciation.

In addition, the extension of the ECB’s asset purchasing plan to sovereign bonds will weigh on sovereign spreads, even though these are now clearly below their equilibrium values, as shown by the Global Financial Stability Report of October 2014 among others. In particular, the rate spread between France and Germany should stabilise at a low level but the risk of additional downgrades to France’s credit rating is growing; in fact, in the IMF’s latest projections (WEO, October 2014), the forecast for France’s public deficit was raised higher than any other country and the European Commission forecasts that it will be the country with the highest deficit in 2016 in the European Union. The debt-to-GDP differential between France and Germany is steadily widening, a gap that will increase by 15% over the next five years according to the IMF. In 2015, France’s net issues will be up sharply while those of Germany will be negative. Thus, the risk is in the widening of the French-German spread over the medium term.

There is little reason to believe that rates will come back up in the eurozone

To conclude, keep in mind 4 key points.

1) Eurozone rates are low for several reasons:

  • A weak economic situation;
  • Extremely low inflation rates in all countries;
  • Extremely low inflationary expectations;
  • Surplus savings that translate in current account surpluses;
  • Declining supply of sovereign bonds because of Germany’s issuing policy;
  • Valuations of risky assets sometimes seen as excessive, which tends to generate periods of declining interest rates, jeopardizing any position that favours increasing rates;
  • Rising volatility, which justifies holding long bond positions to macro-hedge risks;
  • The presence of non-resident, specifically Asian, investors, a situation justified by global liquidity.

2) Rates would head upward if the following conditions were met:

  • A sudden acceleration of growth, a highly unlikely scenario at the present time;
  • An acceleration of inflation, also a highly unlikely scenario, since deflationary fears are still so dominant;
  • An increase in inflationary expectations. Truthfully, only a geopolitical shock leading to a rise in commodity prices - with oil in the lead - would be likely to drive inflation any higher;
  • A return of foreign deficits from the peripheral countries;
  • An acceleration of investment in businesses, and an increase in their financing requirements. With weak capacity utilisation and investment intentions, we cannot consider this a likely scenario. If we also consider the low profitability of businesses in countries like France and Italy, we begin to understand why this is so unlikely.
  • The end of sovereign debt purchasing by non-residents. Note that this would require a reversal of the monetary policies underway, with Japan in the lead;
  • Much more expansionist fiscal and tax policies;
  • The end of debt reduction, including public;
  • A worsening of the perception of the public debt sustainability (see box);
  • The end of cuts in wages and unit labour costs;
  • Higher productivity gains;
  • Improved demographic conditions.

3) We must believe in a certain disconnect between American and European long-term rates

In past cycles, US growth accelerations have always resulted in a rise in long-term rates there and, indirectly, in the eurozone.

Should we definitely be counting on such a scenario now? Nothing could be less sure.

  • Global liquidity keeps US long-term rates low. The Fed has ended its QE, but the BoJ and the ECB are continuing or starting their own programmes. In addition, people are speaking out in the US, and indeed within the Fed itself, to bemoan the end of the QE, and even recommend it be resumed;
  • We are now witnessing a strong economic disconnect between the US and the eurozone, and it is quite difficult not to think that this will result in a greater disconnect between long-term rates;
  • Without a doubt, the ECB’s policy will increase carrying positions that favour euro sovereign debt;
  • The eurozone’s surplus savings since 2012 is driving interest rates down

4) What could be the spanner in the works?

Definitely the exchange rate. Excessive depreciation by the euro would likely discourage non-residents from continuing to purchase European debt. In this sense the eurozone is not like Japan, where the vast majority of debt is in the hands of resident investors (more than 90%). In other words, if the yen’s decline in Japan had little impact on long-term rates and promoted corporate growth and profits, excessive depreciation in the eurozone could push long-term rates up, automatically affecting profits but partially impeding growth.

The PUBLIC DEBT AND SOLVENCY: SOME COUNTRIES REMAIN FRAGILE

The rapid growth of public debt undermined the solvency of many countries and precipitated the debt crisis at the start of the 2010s. Measures taken by central banks and a limited return to growth put off worries of a default and doubts over governments’ ability to repay debts, but it is clear that another collapse in growth would return this thorny issue to the fore. Changes in the debt to GDP ratio essentially depend on three factors:

  • The nominal interest rate paid on existing debt;
  • Nominal GDP growth;
  • The primary balance (difference between government revenue and expenses, excluding debt charges).

Here it is clear how deflation negatively impacts government finances. In addition to an anaemic level of real growth, weak or negative inflation would push up real interest rates—potentially above real GDP growth, contributing to the rise in the debt-to-GDP ratio. Any deflation would seriously undermine the solvency of eurozone countries given that, all other things being equal, government debt would continue to climb. In 2014, nominal interest rates continued to fall, and even more so for peripheral countries, which favours the sustainability of public debt. But growth and inflation also fell at the same time. Don’t forget that the recent decline in nominal interest rates applies only to future government borrowing and that it will be some time before it applies to all public debt and reduces the related debt servicing. This also illustrates how difficult it will be to stabilise the debt-to-GDP ratio. We can no longer expect much regarding the decline in nominal interest rates (the rates at which eurozone governments borrow are close to zero or very near zero for maturities up to five years). At most—and this would already be significant—the ECB could help maintain interest rates at current levels for a long period.

The average interest rate on the “implied” debt burden stands at approximately 2.5% in Germany and France and approximately 3.75% in Italy and Spain: nominal GDP growth below this rate would imply, all other things being equal, a “snowball effect”, whereby nominal debt grows more quickly than the economy. Among the four largest eurozone countries, only Germany has nominal GDP growth above the nominal interest rate. That being said, the gap between interest rates and growth remains too small to significantly reduce German government debt. In Spain and Italy, meanwhile, interest rates are much higher than nominal GDP growth. The “snowball effect” remains a concern, especially given that growth expectations are once again an important factor in determining asset prices.

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6-1

 

 

The cycle of rising Fed Funds rates will be slow

 

6-2

 

6-3

 

 

The ECB is likely to go even further and assume a policy of buying sovereign bonds

6-4

 

6-5

 

Without a doubt, the ECB’s policy will increase carrying positions that favour euro sovereign debt

Excessive depreciation by the euro would likely discourage non-residents from continuing to purchase European debt

The evolution of the debt to GDP ratio depends on the difference between the nominal GDP growth and the nominal interest rates

 

6-6

The “snowball effect” remains a concern, especially given that growth expectations are once again an important factor in determining asset prices

 

Bastien DRUT, Strategy and Economic Research at Amundi
Philippe ITHURBIDE, Global Head of Research, Strategy and Analysis at Amundi
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Yields persistently low in the developed countries
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