March 13th, 2015 | By Nick Sargen
Over the past few weeks European government bond yields have spiked by 50-75 basis points, with the 10-year German bund yield rising from a record low of 5 basis points to as high as 80 basis points. It is currently trading around 70 basis points. According to economists at J.P. Morgan, this is one of the largest and swiftest sell-offs of bunds during the Economic and Union Government Bond (EMU) era, and it appears to reflect an unwinding of positions that investors put on when the ECB embarked on a massive bond-buying program at the beginning of this year.
Nonetheless, while some observers are likening the sell-off to the "taper tantrum" that occurred in the U.S. bond market two years ago, the circumstances are very different: The surge in U.S. bond yields then occurred as the Fed announced it was contemplating phasing down its quantitative easing program, whereas the ECB is still in the early stages of its QE program, which is slated to last through September 2016.
The most likely explanation is that the rally in European bonds had simply gone too far, with short-intermediate yields in many European government bonds falling below zero. Whereas investors previously feared Europe was headed for Japanese style deflation, two developments have lessened these fears: (i) The eurozone has emerged from a mild recession in 2014, and (ii) higher oil prices have lifted headline inflation rates and inflation expectations throughout the region. In addition, the spike in yields may be linked to diminished liquidity in European bond markets.
The question remains, how much further are European bond yields likely to rise? Our view is the eurozone economy is likely to gain traction in response to oil price declines and a weaker currency since mid-2014, as well as improved financial market conditions throughout Europe. Therefore, we view the trend in European bond yields as higher, especially with yields in many countries still near all-time lows. However, we do not foresee an added spike in yields the remainder of this year, considering that economic growth in the eurozone is expected to be modest - 1%-2% per annum - into 2016 while core inflation is likely to remain low.
The back-up in European government bond yields spilled over to the U.S. bond market, where the yield for the 10-year treasury has increased by 30-35 basis points to about 2.25% in the past two weeks. At the same time, the U.S. dollar has softened by about 5% against the euro, after having surged at one point by nearly 25% since mid-2014.
The main impetus behind the dollar's easing is diminished expectations about U.S. economic growth and Fed tightening in 2015: The preliminary estimate for real GDP growth in the first quarter of 0.2% at an annual rate is expected to be revised to a negative number in the wake of a larger-than-expected deterioration in U.S. trade in March. However, it appears the data once again is distorted by a severe winter, and that some of the deterioration in U.S. trade was influenced by a West Coast dock strike. Our call is that the economy will strengthen in the balance of this year, as it did one year ago, as consumers spend more of their windfall from lower oil prices and domestic producers of oil stabilize capital spending and possibly expand production in the second half of this year.
Meanwhile, we do not look for the dollar to strengthen immediately, as investors do not expect the Fed to tighten monetary policy anytime soon. However, the markets will respond to incoming data just as Fed officials do, and expectations could change quickly once the economy regains momentum, especially if the unemployment rate continues to decline. Therefore, we view the dollar's recent softening as a temporary development and look for it to test parity versus the euro later this year.
The third key market development has been a firming in oil prices of $15-$20 per barrel in the past two months, with the price for West Texas Intermediate currently hovering about $60 per barrel versus a low of $42. The upturn in oil prices does not appear to be demand-driven, as global growth in the first quarter was unusually weak and China's economy slowed noticeably.
The more likely explanation is that oil markets are responding to cutbacks in oil production and capital spending in the United States: The rig count in the United States has fallen more than 50% from its levels in mid-2014, and domestic oil producers have cut back significantly on capital spending plans. As forward prices have strengthened, however, some domestic producers are contemplating stepping up their production later this year. Therefore, we think the most likely outcome is that oil prices will fluctuate within broad ranges: Thus, higher prices will induce increased production, which, in turn, will have a subsequent dampening effect on prices. In our view, the key factor that will limit future price increases is the reluctance of Saudi Arabia, as the residual supplier of oil, to cut back on its production. Therefore, we do not foresee further material price increases this year.