A Euro-Surprise Is On The Way – And It Is Not What You Think It Is

Mar 16 2015 | 8:53am ET

By Neil Azous
Founder & Managing Member
RareView Macro
A shock is on the way in Europe. And yet, it is not a sudden Greek exit from the euro, a win for the far-left in Spain, the far-right in France, nor is it another recession, a fresh round of bank failures, or any of the other scare stories that constantly get thrown at us. It is stronger growth. And in turn, rising bond yields.

Over the last 16 months, the dramatic straight line decline in European government bond yields has drawn a lot of scrutiny – and rightfully so. These yields determine the lending rates for a region that contains 335 million people and a GDP of $10.5 trillion. Falling interest rates are beneficial to the consumer, but not without certain costs. That decline in European yields, means the differential between US and German government bonds reached a new record wide level last week. And yet, over the next 6 to 12 months we think that this differential will start to narrow as the European economy continues to accelerate from a low base, helped by the turbo-charged injection of monetary support from the European Central Bank (ECB).

Historically, the “safe” government bond yields of the five major global “hard” currencies have been sensitive to their own countries’ growth and monetary policies. Recently, they have become increasingly sensitive to outside forces as the world has become more and more inter-connected. For example, when comparing the spread between US and German bond yields, the exchange rate and the respective nominal GDP of each country played a dominating role. But with “money printing”, central banks have resorted to effectively selling their own currencies to drive up nominal spending and manufacture demand. So over the past six years, some of those deep historical relationships have started to change. Plenty of people will tell you that European bond yields can’t rise while the currency is falling. We think that is wrong.

The consensus view is that if the German Bundesbank is buying 10 billion euros of Bunds per month, by the time the program ends in September of 2016 they will have hit their limits on the number they can own. From a purely mechanical perspective, that is a legitimate concern because, in simple terms, there won’t be many bonds to buy.

We’ve seen that before.  Take the US, where it was assumed a dramatic fall in the net supply of safe government bonds would cause interest rates to drop in the late 1990’s during President Bill Clinton’s second term when the US had begun to run a budget surplus. At the same time the US Treasury stopped issuing 30-year bonds, creating fears in the marketplace that would cause interest rates to collapse. However, the opposite occurred. Growth and private spending accelerated in 1999-2000, and interest rates rose to reflect the positive economic change.

Another example was more recent. In its attempt to repair balance sheets and prevent the US economy from falling back into the Great Financial Crisis, the US Federal Reserve embarked on two asset purchase programs between 2009 (i.e. QE1) and 2011 (i.e. QE2) where it bought very large amounts of government or agency assets. In both instances, the amount purchased was designed to “shock” the system. A secondary goal of the programs was to manufacture synthetic inflation that would encourage citizens to go out and spend money. In both, they were wildly successful. During both programs, interest rates rose and yield curves steepened to reflect that increase in inflation risk. For example, during QE2, the 10-year US Treasury yield, which is a direct representation of growth expectations, rose about 125 basis points from peak-to-trough during the program. At that time, the Fed was buying more than the total net new available supply for longer maturity Treasuries.

So ultimately, over the long-term, the supply/demand fundamentals are only a small part of what drives interest rates. For the most part, bond yields are influenced by nominal growth expectations – that is, inflation plus growth. And in the case of Europe, from our viewpoint, it is increasingly clear that both of these have turned solidly up.

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