As expectations for the European Central Bank to terminate its asset-purchasing program in September heat up, investors are seeing yields for a growing swath of European bonds turn positive for the first time in years.
The selloff in European sovereign debt, along with Treasurys, comes amid an intense debate within the ECB over whether the eurozone’s economic recovery is on a footing solid enough to warrant an exit from its use of unconventional monetary policy. Market participants say quantitative easing has depressed borrowing costs for European governments to distorted lows as price-insensitive central banks have bought debt regardless of future returns.
On Monday, the German 5-year bond yield
rose above zero for the first time since Dec. 2015 (see chart below). That coincided with a climb in the 10-year Treasury note
yield as it tipped over 2.70%, a key psychological level that once broken through could hint at further yield gains, said traders. Bond prices fall when yields rise.
It’s not just Germany. Bond yields for 5-year maturities in Sweden and Belgium have also recently climbed into positive territory.
Investors like Bill Gross of Janus Henderson have specifically called for a repricing of German rates to reflect the strength in the eurozone’s leading economy. They like to point out the U.S. and German yield differentials should be minimal as the pair are seen as highly liquid haven investments and, as such, command similar appetite from foreign investors.
But even after Monday’s selloff in European sovereign debt, German bonds were largely matching the movement of Treasurys, failing to narrow the wide gulf between the two assets.
The spread between the 10-year Treasury yield and the German 10-year bond has only slightly narrowed to 2.10 percentage points. At the moment, the current difference in yields are overall much wider than the levels seen in midsummer of 2017 when investors speculated major central banks like the ECB and the Bank of Japan would join the Federal Reserve on the path to ‘normal’ monetary policy.
Like then, Monday’s selloff had similar roots.
Dutch central bank chief Klaas Knot, a member of the ECB’s Governing Council, ignited the selling after he said on Sunday, “there is no reason whatsoever” for the ECB to prolong its asset purchase program beyond September. The ECB has left open the possibility of extending the program beyond that date if warranted.
The Dutch central bank president has been a vocal opponent of quantitative easing as pension funds in Netherlands have complained low interest rates have hamstrung their ability to meet their targeted returns, widening their funding shortfalls.
But on the following day, ECB chief economist Peter Praet said the central bank would only end its monthly bond-buying program if eurozone inflation approached the ECB’s 2% target. His stance echoed ECB President Mario Draghi after he indicated the central bank was nowhere near hiking interest rates this year in last week’s press conference.
Since then, European government bonds have come under sustained pressure. Carl Weinberg, chief economist at High Frequency Economics, said the disconnect between Draghi’s dovish comments and the market’s hawkish reaction suggested investors are expecting inflation to outpace the central bank’s projections.
“Is the market looking for more inflation to blindside a complacent ECB?” he asked. The eurozone inflation reading for January is set to come out on Thursday.
Indeed, some analysts expect upcoming economic data and changes to future policy language could help short-dated yields in European government bonds rise further.
“Draghi admitted that the ECB’s discussions on forward guidance were ultimately ‘data dependent,’ with the current guidance appropriate based on ‘today’s data.’ As a result, front-end rates, and future forward guidance, will likely be more data driven and susceptible to upside surprises,” said Sphia Salim and Ruairi Hourihane, rates strategists for Bank of America Merrill Lynch, in a note.
But others were less sanguine. Based on the current trajectory of price pressures, analysts at Pictet Asset Management said the ECB was likely to punt the end-date of its asset-purchasing program to early 2019.