World bond prices have surged higher recently on expectations of more central bank stimulus around the world. The week of June 2 is expected to be a busy one, with the ECB, Bank of England, Bank of Canada and the Reserve Bank of Australia all scheduled for meetings. The European Central Bank (ECB) is generally expected to lower rates at its June 5 meeting, with the possibility of a negative rates policy being adopted. The Fed, too, continues to stress that it will remain accommodative for a long time to come, while China is working on policies to support its transition to a consumer-driven economy. To say that the recent surge in bond prices has caught many portfolio managers off guard is perhaps an understatement, triggering a race for yield.
In December of last year, the Fed announced intentions to begin tapering its monthly bond purchasing program, with the hope of ending Quantitative Easing (QE) altogether by late fall of 2014. We initially saw the long end of the Treasury curve moving lower, pricing in higher rates in 10 years time. With the punch bowl slowly but surely draining, the economy slowed in reaction to the start of tapering in January of this year, exenterated by the extremely cold weather across significant parts of the United States as well as a leadership transition at the Fed. Major transitions of this nature always constitute an adjustment, forcing the markets to learn a new language of Fed communication. After initially hinting at a six-month break between the end of QE and the start of the Fed’s tightening program, Janet Yellen moved to adopt vaguer language, taking some by surprise.
This week’s revised GDP figure of -1% confirmed that the economy did, in fact, slow during the first quarter of the year but a number of economists are looking for the economy to bounce back, giving the United States a better second quarter. Besides the difficult start to the U.S. economy, Europe’s economy struggled also; with fears of deflation putting pressure on the ECB to begin thinking creatively about viable stimulus options. As a result, we have seen bonds across Europe grinding higher over the last couple of months, reluctantly dragging U.S. bonds along with them. This put a lot of pressure on those who had higher yields priced in, triggering a number of short covering rallies along the way.
Besides outright positions held in Treasuries there are a number of spread relationships that came under pressure also. While the Treasury 5- vs. 30-year spread initially steepened out to about 256 basis points just before the December Fed meeting, it has since flattened to 178 bps as portfolios adjusted to new expectations. Corporate bonds have seen renewed interest as portfolios look for something with yield.
This week, the markets will be monitoring the upcoming ECB meeting, with mixed expectations as to what type of policy Europe’s central bank will pursue, and how aggressive that policy will be. If history is anything to go by, the ECB has not been nearly as aggressive as the Fed, which may help explain why the ECB has to intervene again. Should the ECB take an aggressive stance, we should see European bonds continue to outperform U.S. bonds; however, if it disappoints and decides to move slowly, look out for the possibility of a correction. On the other side of the Atlantic, the tapering course seems set in place, due to reach completion in the fall of this year. Between now and then, interest will shift towards tightening, with upcoming economic data likely dictating the start and eventual pace of that process.
US 10-yr bond future (TYU4) minus the German Bund 10-yr future (RXU4):
Source: Bloomberg Finance L.P.
Going into this week’s ECB meeting, there are a number of ways to express expectations on the Central Bank’s new course, one being the use of the futures spread between the U.S. 10-year note and the German Bund 10-year futures and another being an options play with liquidity not posing an issue. Since late December of last year, the Bund has steadily outperformed the U.S. 10-year, pricing in the weaker European economy.