Against the tide: Populist threat held off but don’t expect bond rally
The populist surge is being restrained for now, but several factors are likely to drive up sovereign bond yields in Europe.
As I suggested in my last column, the populist threat to European unity will not materialize this year.
The election in the Netherlands did not deliver a victory for the far-right, anti-immigration PVV, and a pro-EU coalition will make up the next government.
All the polls show that Front National leader Marine Le Pen will not win the presidency in May. The populist Five Star Movement in Italy is leading the opinion polls, but a general election in Italy is unlikely to take place before May 2018 now.
And in Germany, the pro-EU Social Democrats are neck and neck with the pro-EU Christian Democrats in the opinion polls for September’s federal election. Spain has a constitutional crisis brewing with Catalonia that needs watching, but economic recovery there should take some of the sting out of secessionist zeal.
The populist surge is being held off for now. However, that does not make for a bond rally in Europe. On the contrary, there are several factors likely to drive up sovereign bond yields this year.
The backdrop is global reflation. The world economy is in a synchronized upswing. This is bound to push inflation higher given poor productivity, tightening labour markets and waning spare capacity.
Global bond markets are still mispriced due to central bank action, but that is ending in the US and will end soon too in the eurozone. The EU economy is finally growing robustly. Inflation is finally on the rise. So the European Central Bank (ECB) monetary tightening is a sure thing for 2018.
Moreover, the UK seems set for a hard Brexit and rudderless with no clear strategy. The risk of the UK breaking up is rising. The next Scottish referendum will not only be about nationalism but membership of the EU. Nearly two-thirds of Scots voted to stay in the EU in last summer’s referendum. Their will is being thwarted by Westminster, a game that might ultimately prove counter-productive.
The same applies to Northern Ireland where, for the first time, the Unionists – having lost the referendum – have also been big losers in the parliamentary election. They are down to a one-seat majority in Stormont.
Talk of a united Ireland now seems more realistic as it is based on economics – the loss of a seamless border with the Republic and access to EU markets by that route – as much as nationalism. The peace process and generational shifts, both among the political classes and population overall, as well as economic integration with the Republic have begun to neuter some of the traditional hostility among Protestants to the concept of unification.
At the same time, the UK economy seems at last to be suffering from the erosion of purchasing power by sterling-induced inflation. All of this smacks of stagflation, a constitutional crisis and rising political risk. UK gilts will suffer.
Ironically, a positive outcome in the French election will cause Bund yields to rise as the money, parked there as a hedge on the euro’s demise under Le Pen, exits, but it doesn’t stop there: the economy and the end of ECB quantitative easing will turn rising Bund yields into a trend.
Moreover, the periphery of Italy, Portugal, Ireland and, of course, Greece still have major debt sustainability issues in a rising interest-rate environment, though it will take time to unfold. Spain has better debt sustainability, but not sufficient to prevent its sovereign yields rising along with the other peripherals.
French sovereign bond yields are likely to rise. They will rise if Le Pen gets into the Élysée, calls a referendum on EU membership and attempts to implement an absurd economic policy. She has offered up a classic populist economic policy, promising more of everything to everyone while ignoring the fiscal costs and economic implications of the protectionism that binds her “France-first” policy.
There is nothing there that would revive productivity and lead to a revival in growth, which is what France needs. Of course, the political reality is that Le Pen would probably not be able to take France out of the euro, but she would try to markets will reflect that.
And even if Le Pen does not win – as is most likely – French yields will follow Bund yields up, with rising European inflation, economic recovery and ECB monetary tightening. So it’s a bond yield rise in Europe this year.