Negative euro-zone bond yields epitomise everything that’s wrong in markets
Sub-zero-yielding debt has allowed European market sentiment to become dangerously detached from countries’ underlying fundamentals
For an indication of the breadth and depth of the distortions in financial markets, even as the US Federal Reserve begins to normalise monetary policy and speculation mounts over the timing of an end to quantitative easing in the euro zone, look no further than the renewed increase in the global stock of negative-yielding government debt.
This Alice-in-Wonderland world of sub-zero interest rates – bonds which, if held to maturity, result in a loss for investors as bondholders effectively pay governments for the privilege of lending them money – appeared to be slowly returning to normal towards the end of last year.
Yet in its latest negative yield index monitor, published last month, which tracks and analyses the international stock of sovereign bonds offering yields below zero per cent, JPMorgan notes that the share of negative-yielding debt in its benchmark index for government bonds in developed markets has been rising again over the past few months.
The increase, moreover, is attributable to the renewed decline in bond yields in Europe, a region that has been enjoying surprisingly robust economic growth this year and which, under the normal circumstances, ought to be experiencing a rise in yields as economic conditions improve.
However, according to JPMorgan, while the stock of negative-yielding bonds in the index for government bonds in developed markets has fallen significantly from a peak of nearly US$13 trillion in July 2016, it started rising again in March, increasing from just over US$8 trillion in February to nearly US$10 trillion by mid-April before retreating to US$9.2 trillion in early May.
The main reason for the renewed increase is a reduction in perceived political risk in the euro zone following the victory of pro-European centrist Emmanuel Macron in France’s presidential election last month.
Since the first round of the election in late April, when it became clear that Macron was a virtual shoo-in for the presidency, the stock of negative-yielding debt in France shot up by US$60 billion, according to JPMorgan, helping drag down yields elsewhere in the euro zone, especially in Italy which, given the country’s political and banking-sector woes, would have suffered the most from a victory for the far-right in France’s election.
France’s 10-year yield, which was above 1 per cent in mid-March, has sunk to 0.7 per cent (pretty much where it stood at the beginning of this year) while its two-year equivalent is once again falling deeper into negative territory, dropping to minus 0.5 per cent.
What is more disturbing, however, is that even short-term borrowing costs in Italy – the next focal point of investor concern in Europe following the favourable outcome of France’s election – are back in negative territory after being positive for most of this year.
According to JPMorgan, as much as US$450 billion of Italian government debt is now trading with a negative yield, accounting for nearly one-sixth of the 35 per cent or so of bonds in JPMorgan’s benchmark euro-zone government bond index currently in negative territory.
That even in the euro zone – whose economy grew by a faster-than-expected 0.5 per cent in the first quarter of this year (outpacing the US) and which is expected to expand by an even brisker 0.7 per cent in the second quarter – more than a third of government debt still trades in negative territory shows just how distorted global asset prices have become.
Much, if not all, of the blame lies with central banks, especially the European Central Bank and its Japanese counterpart, whose aggressive quantitative easing programmes are keeping bond yields anchored at historically low levels despite a pick-up in growth and inflation in both regions, most noticeably in the euro zone.
In last month’s global fund manager survey produced by Bank of America Merrill Lynch, a record number of respondents claimed that global monetary policy had become too loose.
While the ECB’s caution over withdrawing stimulus is justified, given the persistently subdued level of core inflation (which excludes volatile energy and food prices) in the euro zone, it borders on the absurd that as much as US$3 trillion of the bloc’s government debt is still trading with a negative yield in a region whose economy is enjoying its fastest growth in six years.
Quite aside from the damaging effects of negative yields on the performance of long-term institutional investors, particularly pension funds and insurers, sub-zero-yielding debt has allowed market sentiment to become dangerously detached from countries’ underlying fundamentals.
France may have averted a full-blown crisis by electing Macron as president, but Italy may not be as fortunate when it holds a crucial parliamentary election, possibly as early as this autumn.
In the coming months, negative-yielding Italian bonds may emerge as the most conspicuous case of mispricing in global markets.
Nicholas Spiro is a partner at Lauressa Advisory