BÜCHSE DER PANDORA
Eurostat reports that there was roughly € 2 trillion of outstanding German government debt at year end 2019. ALL German government bills (Bubills) and bonds (Bunds) have a negative yield, which simply means that bondholders are prepared to pay the German government an annual fee to lend their money to the German Government, be it at -0.65% for very short term debt to -0.52% for 10yr debt to -0.13% for 30 year debt.
Did the yesterday’s German Constitutional Court ruling just change the risk/reward for investors in European government bonds?
The current 10 year Bund yield of -0.52% can be broken down into two components:
+ 0.48% Inflation Breakeven Rate.
- 1.00% Real Yield.
INFLATION BREAKEVEN RATE
This is a market-based measure of expected inflation. Simply put, the breakeven rate is the inflation rate that would have to be generated over the course of the lifetime of the bond for an investor to receive the same return from an inflation linked bond (linker) as for a fixed rate coupon bond. If the resulting inflation rate is higher than the breakeven rate when the linker was bought, then the return from the linker would be higher than a fixed rate coupon bond and vice versa if resulted inflation was lower.
The inflation breakeven rate is purely a mathematical calculation and will be compared to actual realised inflation. Currently inflation breakeven rates are at the great Financial Crisis (GFC) lows in Europe and the US, reflecting the likelihood that inflation will be low in the near term. This makes sense given the post GFC experience and the probability that there will be an excess supply over demand environment in the short term until economies recover. Bear in mind
Services dominate Developed Market (DM) inflation baskets – goods are a relatively smaller proportion. For example, in the US, the basket is comprised of Services (59% of the CPI basket), Goods (20%), Food (14%) and Energy (7%).
Although there will be disruptions to supply chains of goods, which will be a negative supply shock, this will be countered by lower consumer demand (car demand is currently almost zero).
Recent (high) Food and (low) energy inflation mean revert in one years time unless there is the exact same increase/decrease in prices in the next 12 months, so higher/lower inflation today will very likely be countered in once year’s time by lower/higher inflation (so called base effects).
As long as there is government assistance to prevent wider private company bankruptcies, which would bring a serious service and good sector supply shock to levels BELOW current lower demand levels, it should seem reasonable that inflation markets are pricing low inflation outlooks and are not too worried about hyper inflation in the near term. Japan showed just how long zombie companies can be kept on refinancing oxygen, as did most DM governments post GFC. If anything, there is the risk of further disinflation or a mild dose of deflation in the next 2/3 years. To sum up, investors can justify holding their investments of Bunds with a ~0.5% 10 year breakeven inflation rate.
Conventional bond market wisdom is that a Real Yield gives an indication of the market’s expectations of future GDP growth rates, combined with an assessment of the credit quality of the underlying sovereign debt issuer. This might have been true pre GFC, but there is just too much evidence to show that this is no longer true after Central Banks (CBs) took rates to zero and started increasing their balance sheets to finance government bond debt. The clearest example is that 30yr UK Real Yields have been negative since 2014, due to the Pension Industry Asset/Liability Management (ALM) stress.
Post GFC CB interference in bond markets, a better way to determine the current and expected real yield of a bond is simply understanding the expected government bond supply vs the demand dynamics for bonds.
The supply side of the equation is the “easier” (or less hard!) part of the equation to fathom. Debt trends are a bit like an oil tanker – slow moving and in a pretty clear direction. This is also the case during the current pandemic because the GFC period laid down a very good template on potential debt increase sizes and how that increase in size is attained. Indeed today’s US Treasury announcement on next quarter’s funding was entirely predictable – separate post to follow.
The market knows that there will be a large supply of new bonds in the forthcoming 12 months as debt issuance has already started in the form of short dated Bill issuance. Over time, as these Bills mature, Treasuries the world over will start replacing the maturing Bills by gradually issuing longer dated bonds in order to keep a decent average maturity profile for the outstanding debt stock (this post shows how the US Treasury carried this out post GFC, with real numbers and charts). Its not that hard to model.
What is more complicated, but perhaps less so post QE, is to understand what the demand for existing and new debt will be. There are three sources of demand, listed in investor “stickiness” of holdings:
Central Banks (through their Quantative Easing programs).
Foreign Investors (predominantly Central Bank Reserves)
Private Domestic Sector Savings (Insurance cos, Pension and Mutual Funds, Banks and Private Individuals)
Central Banks will maintain the stock of their own country’s debt whatever might happen to rates or supply.
For DM country debt, private foreigners who follow index benchmarks (e.g. bond funds etc) have tended to remain invested, as have Central Banks who need to maintain FX Reserves (predominantly on the short end of the curve). This has been the case over the last 20 years, despite rate increases and huge increases to debt supply. For example, from 2002 to 2019, foreigners have accumulated $4.6trn of the $12.3trn increase in US Treasury debt. Only twice have they reduced their net outstanding holdings in those 17 years (by $160bn in 2016 and $ 15bn in 2018). The same is true for the UK, where foreigners have accumulated £524bn of the £1,734bn increase in Gilts since 2000, with only a £4bn and £13bn reduction of outstanding amounts in 2013 and 2014 (the data is harder to analyse as the DMO releases it on a market value basis).
On the private domestic front, insurance companies and pension funds have needed assets that match their “fixed income like” liabilities, whilst banks have needed to buy for collateral and minimum liquidity regulation reasons.
Over the last 20 years there have only been 3 major shocks to the balance of supply/demand that have caused a sudden move higher in real yields in the US, Japan, UK or Germany:
During the 2008 GFC, when markets did not know who would fund the extra fiscal debt so yields rose to entice private sector demand. QE was eventually announced and yields subsequently declined.
The 2013 “taper tantrum”, when the Fed announced it was going to reduce its purchases of USTs. Real yields rose in the US, UK and Germany.
The most recent rise on the pandemic outbreak when governments announced big fiscal measures BEFORE Central Banks announced their QE programs to buy up the supply.
And this is the rather large elephant in the room. Foreign and Domestic holders of debt are ONLY invested in the knowledge that there will not be a material increase in the net supply of debt. If there was such a debt increase, yields would rise, just as they did in those three shocks shown above, causing significant losses to portfolios. Current holders and future buyers of DM government bond debt have complete trust in a country’s Central Bank hoovering up any excess supply that might cause real yields to rise.
But is that assumption safe? Both the Fed and then Bank of Japan have promised an “unlimited” expansion of their balance sheets, and their actions have been matched by words. The Bank of England has been very prompt, even promising to credit HM Treasury’s “Ways and Means” account at the BOE with what is required.
The ECB has been notably behind the curve in its promptness to promise it will also toe the line and buy excess government bonds. This is in part due to the North/South politics, but also due to the unfortunate and inopportune timing of the change of the President of the ECB. And just when the ECB was already struggling to hold its own, enter the German Constitutional Court (GCC) to stir the hornet’s nest with their judgement on the ECB's legality with respect to its decisions on the Public Sector Purchase Program.
It is really of little importance whether the GCC has a point or not regarding the ECB needing to carry out a “proportionality assessment” of its QE program, or whether it is right or wrong in claiming that negative side effects need to be better explained. The key issue is that the GCC has made the ECB need to justify what it does and if it does not, then after a transition period of 3 months “the Bundesbank may thus no longer participate in the implementation and execution of the ECB decisions at issue”.
Despite all the evidence that QE does not work in raising CPI or growth, it would go against European politics to not expect a solution that satisfies the GCC. But at the same time, even if the GCC have not necessarily opened pandora’s box, they have found it, brought it onto the world stage and displayed it to all and sundry, perhaps even cleaning the lid in case it needs to be opened. The North South divide just gaped further wider.
And that's where risk reward comes in. A Bund investor will still expect to receive the mathematically linked 50bp inflation return. But does it make sense to still pay 1% to the German Government when there is the risk that the Buba will not buy known large future debt issuance, let alone sell its existing holdings? What’s the upside of holding a 10 year Bund at -50bp vs the downside? The sums involved are very large.
Naturally this does not just apply for Bunds, but for all European Government Bonds. A recent post highlighted how both Italy and Spain already have difficulties with issuing new debt supply. The GCC decision will only add to those problems. For the last 20 years I have been a Bund bull, regularly highlighting the best fixed income strategist on the street (below). Without the crystal clear 100% guaranteed security that the Buba will be there to buy new supply or keep its existing holdings, the risk reward for holding Bunds makes it an extremely unattractive proposition. There are far better investments!