During the second half of May it seemed that the technical re-set in the German government bond market had run its course, but renewed selling in Bunds in the past two weeks has again pushed yields higher. An unexpected upward blip in Eurozone May core inflation and improved macroeconomic data raise the question of whether the latest yield spike has a more fundamental side.

German bond yields and volatility have increased again

15-06-2015 Market Express Bund market bears still on the loose EN Graph

At the beginning of this month, bond markets had calmed down after the sell-off that had taken German 10-year bond yields from an April 20 low of about 7 basis points to more than 71 basis points by May 13. Yields trended lower again in the second half of May and most investors seemed convinced that low inflation and the European Central Bank (ECB)’s commitment to quantitative easing (QE) would keep yields stable at a “normalized” but still very low level.

Technical correction showed no signs of risk aversion

This view was also reflected in other parts of the market. The April-May sell-off was not accompanied by any signs of broad-based risk aversion in global markets. For example, the Chicago Board Options Exchange Volatility Index (VIX), a well-known indicator of risk aversion, remained remarkably stable during April and May. Also, the first stage of this Bund correction was completely driven by real yields, with no re-pricing of inflation risks.

All this created the impression of a technical correction from overbought levels in Bunds. Ripple effects were evident in related segments of the market such as the euro exchange rate and European equities, but fundamental drivers or signs of global contagion in markets were hard to find.

Most recent sell-off has brought increased volatility

Since early June this picture has changed. As the chart shows, 10-year Bund yields have again increased substantially, as have the daily and intraday jumps. The unusually high levels of volatility in Bund yields still hints at technical factor being at play; the underlying fundamental picture is unlikely to change so much during a given day.

At the same time, an upside surprise in European inflation data and a tentative improvement in global data surprises may have added a bit of fundamental colour to the bearish Bund view. This is partly also reflected by a recent modest rise in inflation expectations and small but more broad based signs of risk aversion. The VIX has started to move up, the US dollar has strengthened after weakening in April and May and emerging markets have started to underperform again.

Draghi remains committed to QE

Amid the improved macro data and the upward blip in May core inflation, some pundits have started to entertain the notion of earlier-than-expected “tapering” of ECB QE — earlier, that is, than September 2016. ECB President Mario Draghi doused these expectations at the bank’s last press conference, where he clearly signalled that the ECB is in it for the long haul.
The only possible changes to the program Draghi mentioned were in the direction of “doing more”. This could happen if the ECB were confronted with an unwarranted tightening of financial conditions or a growth slowdown. The bank is still far removed from a threshold that would trigger such action. The volatility seen in bond and currency markets certainly does not entail a tightening of financial conditions that would warrant action.

ECB is looking through recent volatility

Draghi said the ECB’s Governing Council is unanimous in its intent to look through the recent market volatility, which in the ECB’s view was driven by technical factors. These include overbought Bund levels, as well as the tendency among investors to reduce the size of their positions automatically when volatility increases. Moreover, market liquidity is sometimes thin and net issuance is low.

Maintaining a steady course in the midst of market volatility is a sensible strategy. It is the central bank’s job to provide stability in the financial markets; if the ECB were to react to each and every bout of market volatility it would only add to the turmoil. But at some point a market sell-off can create its own economic reality and necessitate a monetary policy reaction. Identifying that point is part of the art of central banking.

Output gap may be larger than the ECB thinks

Draghi also revealed that the ECB is pessimistic on the supply side of the economy, saying the non-accelerating inflation rate of unemployment (NAIRU) was around 9% before the crisis and implying that it is higher today. The NAIRU rate is seen as the  unemployment level consistent with constant inflation, corresponding to a so-called output gap of zero. The ECB’s forecast of an end-2017 unemployment rate of 10% implies that the central bank expects the output gap to be nearly closed by then. This suggests tapering could occur soon after September 2016 with a first rate hike in 2017.

We believe the output gap is much larger than the ECB thinks. Even today GDP in the euro region is still some 1-2% below the 2008 peak so there seems to be ample room for the economy to grow before it hits supply side constraints. Stronger growth could also elicit stronger supply, for example via an increase in productivity growth. In addition to this, we fear that below-target inflation expectations have become somewhat detached from their anchor; re-attaching them could then well require some overheating.

Shake-out may not be over

The possibility of a fundamental aspect in the latest bout of volatility suggests that the outlook for the Bund market remains surrounded with significant uncertainty and that the technical shake-out might not be finished after all. We are not convinced that this will start sending persistently bearish signals for government bonds, though. We expect low inflation and QE to be around for some time to come.

We do acknowledge that the strongly intertwined global bond market now has very little valuation anchor to prevent bond yields from swinging another 50 basis points up or down in the coming months. Signs of shifting direction in growth and inflation and investor positioning and flows will drive the future evolution of yields, and the “fair value” level of bond yields will be more an intellectual guessing game than a driver of future direction of markets. There are more than enough reasons to stay cautious on government bonds.

On other parts of the market we have not changed our constructive medium-term outlook, but our short-term conviction remains low. This translates into small and diversified tilts towards risky assets with equities and real estate as small overweights and fixed income spread products and commodities as small underweights.