|Mario Draghi, president of the European Central Bank|
On Wednesday, Bank of America Merrill Lynch (BAML) published its latest investor sentiment survey based on responses from 207 fund managers overseeing $586 billion in assets under management.
It found that bearish investors are holding 4.9% of assets in cash, above the 10-year average, and that they consider a crash in global bond markets and a policy mistake by the Fed or the ECB to be the biggest tail risk the markets face today.
Ronan Carr, European equity strategist at BAML, says: “Investors expect eurozone inflation to rise and find monetary policy too stimulative, putting the ECB’s signaling powers to the test.”
However, uncertainty reins over Europe and the ECB. In late June, Mario Draghi, president of the ECB, famously told the forum on central banking at Sintra in Portugal that “the threat of deflation is gone and reflationary forces are at play”.
No doubt Draghi would be happy if they are, but not everyone believes it.
The July BAML investor survey finds that while 51% of investors expect the European economy to strengthen over the next 12 months, they are becoming more sceptical about this. As recently as June, 61% of investors were bullish on the European economy and, presumably by extension, bearish on bonds.
How is this playing out in the debt capital markets (DCM)? With a touch, it appears, of schizophrenia.
“There’s quite a weird mood at the moment,” reports Demetrio Salorio, global head of DCM at Societe Generale Corporate & Investment Banking (SG CIB). “On the one hand, it would appear likely that the ECB must taper at some point, but inflation remains low. There is no consensus where rates will go. It feels almost like anybody’s guess.”
Market interest rates have certainly been picking up. Indeed, in the month from mid-June to mid-July, yields on 10-year German Bunds more than doubled from 23 basis points to 54bp. And yet at the very moment when investors might be expected to shun duration, many are doing the opposite.
“Investors have been keen to buy long-dated bonds,” says Florian Moosauer, managing director and head of rates sales for Europe at SG CIB. “When we launched the dual tranche eight-year and 31-year benchmark bond for the European Financial Stability Facility early in July, there was massive demand and we sized the 31-year portion at €3.5 billion, bigger than the €2.5 billion eight-year portion.”
The €6 billion two-tranche issue generated total demand of well over $10 billion, with the order book for the 31-year tranche alone reaching €6.6 billion. The borrower priced the largest deal it had achieved in the 30-year maturity area since 2014 at a yield of just 1.844%.
“When you look at the order book, this was predominantly real money,” says SG’s Salorio.
Fund managers, pension funds and insurance companies took three quarters of the 31-year tranche, with banks accounting for most of the rest. “This was not hedge funds putting on short-term relative value trades,” says Salorio.
Some bond traders are growing impatient.
The head of rates at one non-European firm says: “It seems to us that the ECB may be a little behind the curve, given continuing strong growth. The eurozone economy has grown for 16 consecutive quarters.”
Reinhard Cluse, economist at UBS, suggests: “ECB policy normalization is now under way. Given solid eurozone growth, sentiment at multi-year highs, much-reduced political uncertainty, and anticipation of growing technical challenges to the QE [quantitative easing] programme next year, we expect the ECB to announce on September 7 that it will start tapering QE as of January 2018, a process we believe will eventually last for six to nine months, in a data-dependent fashion.”
While ECB comments at Sintra at the end of June were interpreted hawkishly and fuelled the mini sell-off in European bonds, analysts see this as the ECB trying to warm up the markets well in advance of the end of balance-sheet expansion.
The ECB doesn’t want a repeat of the Fed’s infamous taper tantrum in 2013 when investors panicked and yields surged. ECB briefings after Sintra pointed to still low inflation.
Analysts at Deutsche Bank suggest: “Sintra was not just about sending a hawkish message. It was also about expressing a healthy degree of unease at the pace of inflation normalization and hinting that the end of QE did not mean fast normalization in policy rates.”
It’s almost as if the ECB believes that repeatedly crying wolf might be the best way to prevent a bond market panic – either that or the governing council is split.
SG’s Moosauer says: “Our expectation is that the ECB will announce an extension of the asset purchase programme at its September meeting, taking it out to June 2018, perhaps also announcing a reduction in its size from €60 billion to €40 billion. From then on it will likely be data dependent.”
There are big wage negotiations due to start in Germany at the end of this year.
“It may be that the ECB will be able to reduce the APP [asset purchase programmes] by €10 billion per quarter over 2018, ending the APP in March 2019, assuming a recovery of core inflation – keep an eye on the German wages at the start of 2018 and the Italian elections,” says Moosauer.
However, analysts are pointing again to weak consumption in Europe and low wage growth.
Salorio adds: “What we are saying to borrowers is that this is almost a unique moment. Rates are very unlikely to go down from here, but there is still the opportunity to get long-dated transactions done in decent size at competitive spreads.”
Low bond market volatility reduces primary market execution risk and allows issuers time to plan deals, market to investors and launch at the optimum moment without undue concern that they might miss a window to issue or move terms against themselves.
If it is a good moment for borrowers, times are not so happy for banks or investors. That prolonged low volatility is making it tough for banks to profit in the secondary market.
Cheap vol should make it a sensible time for investors to hedge against rising rates in the derivatives markets, but record low yields offer bond investors little running income with which to buy long-dated options, even while those options are theoretically inexpensive.
“We have putting on systematic swaptions trades for some investors seeking protection against rising rates with pay-outs structured around total return swaps,” says Moosauer.