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What happens when the euro zone and Japan export their low interest rates…

The BoJ’s and ECB’s quantitative easing (QE) policies and negative key rates have nudged bond yields into negative territory. About 80% of Japanese sovereign debt is now trading at negative yields, and about 50% of euro zone sovereign debt (with, obviously, very broad differences between individual euro zone countries). It is now abundantly clear that these two very large markets are “contaminating” other sovereign debt markets and, in particular, the US Treasury market.

One of the most remarkable consequences of low bond yields is that investors’ are increasingly seeking out yields, particularly outside the euro zone. Each basis point counts. A significant share of liquidity freed up by the ECB’s QE (€240bn per quarter beginning in Q3 2016) is being used to buy up foreign bonds. In Q1 2016, euro zone investors bought a net €152bn in foreign bonds, including €79bn in US bonds (unprecedented).

Portfolio outflows in the euro zone and Japan are now very heavy and are offsetting the significant current accounts surpluses (which are hovering respectively around 3% and 4% of GDP) and even more. This is keeping the euro and yen artificially low (incidentally, this also raises the matter of what would happen if, one day, the ECB and BoJ would like to stop their purchase programmes).
These portfolio flows from the euro zone and Japan are exerting heavy pressure on long US bond yields, which are already under pressure throughout the yield curve by reinvestments of maturing Treasuries owned by the Fed ($232bn for 2016). Purchases by European and Japanese investors, as well as investors from Asian countries outside of China, are more than offsetting the sale of Treasuries by Chinese authorities.

Low interest rates are raising lots of questions for the Fed. The FOMC’s June minutes, for example, contained this sentence: “Actions by investors to shift their portfolios away from very low-yielding foreign sovereign debt was cited as adding to the downward pressure on U.S. yields.” And it is not the outlook for Fed tightening that will help raise US long yields significantly. The release of Q2 US growth figures and the downward revision of Q1 figures dampened the mood considerably! Year-on-year growth was just 1.2% in Q2, well below its potential.
Obviously, yields will stay low for some time to come in Japan and the euro zone. But it is now increasingly clear that they will do so throughout the developed world, even in countries that are faring better economically.





DRUT Bastien , Fixed Income and FX Strategy
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What happens when the euro zone and Japan export their low interest rates…
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