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Simon Fasdal
Saxo's head of Fixed Income,Simon Fasdal, says it's time to buy German bunds. He expects volatility to pick up ahead of the Eurogroup meeting over Greece later this month and with the threat of contagion to southern Europe. He explains his Bund Future June trade.
Article / 28 July 2014 at 10:07 GMT

Should we fear higher yields?

Head of Fixed Income Trading / Saxo Bank
Denmark
  • Calls for "Bond Bubble" get louder
  • Wage levels continue to assimilate on global scale
  • Fear of rising commodity prices exaggerated
By Simon Fasdal

It seems like a never-ending story when looking at European and, especially, German 10-year yield levels. Indeed, trading at 1.15 percent, there are not many rational investment arguments for entering a long position in 10-year German bonds at roughly the same levels as those of German CPI (1 percent). 

That is also the main reason why economists believe it is a good time to shout "Bond Bubble" out loud. Looking at the yield level and the timing, I could well agree with them. 

However, there are reasons why German yields could go even lower and stay there for a very long time.

First of all, let's kill the inflation argument. The real yield investment case for German bonds has not been attractive for years so the sensitivity towards inflation is low, as long as inflation is a random walk, trending down. And that is exactly what it is, especially in Europe. 

There is no sign of sustained inflation and no sign of where it should come from. 

Because of continual corporate globalisation, the pricing power in the labour component makes very little sense in the equation. One could argue that inflation is on the rise in some of the emerging market economies, which is correct, as wage levels continue to assimilate on a global scale. However, at the same time and for the same reason, pressure on developed economies is very weak.
German 10Y & CPI & Commodities


















The fear of rising commodity prices is also exaggerated. Commodities are on a path trending down if anything, despite recent spikes in oil, due to geopolitical crises. And while we are talking of higher oil and geopolitics: escalations are very likely to hurt growth and equity markets rather than spike yields and inflation.

Looking at inflation and growth on a global scale, there is no sign of an imminent push upwards. Rather, a modest and stable development is more likely.

Global CPI & GDP
















Secondly, while the US economy seems to be improving, there are views that the European Central Bank's attempts to boost the economy will once again lose traction, and that Europe will continue a sub-global growth path for many years to come. That will put Europe dangerously close to the Japanese deflationary no-growth trap. In that case, European yields could go even lower from here. 

Thirdly, the financial regulatory landscape since the financial crisis has changed drastically. Because of stricter capital rules, banks have to hold more safe assets, where especially, AAA government bonds are in demand. On the other hand, the number of countries with the pure AAA rating is lower, as are the overall developed countries sovereign ratings. This mechanism will effectively push the bank's placings into low capital cost areas (such as high rated bonds), and keep it away from exposing its balance sheet to higher-risk areas such as SMC lending in southern Europe.

So, all in all, there are reasons why economists could be wrong, and premature on their call. To compare, Japanese 10-year yields have been below 2 percent since 1999, and are trading at 0.53 percent at the moment, still on a downward trend.

Add to the picture the fact that Banks and Asset Managers, in general, have a very hard business case when yields are low. The entire financial system would see it as a relief if core yields were to shoot up. This would bring in higher bond trading activity, higher volatility, and higher earnings, and it would also be easier for fund managers to justify a 1 percent fee on a core bond portfolio, if core bonds actually yield more than 1 percent. With so many huge widespread interests in higher yields, chances are it will not happen anytime soon.

Let's summarise the present situation. Is there a bond bubble looming? Perhaps. Is it about to blow? Not at all. Present geopolitical worries (Ukraine and Middle East) is likely to push core yields lower. Inflation is not in sight. While global economics slightly improve, they still seem quite fragile.

That also brings me to the believe, that a combined emerging and developed markets bond portfolio yielding 5-7 percent is a decent return, taking all factors, especially the lack of inflation, and the hunt for yield pickup into consideration. Despite recent rallies and the Argentina deadline, selected LATAM looks attractive. For risk-seeking investors, picking up geopolitical risk premiums in Russia and the Middle East could end up being the trade of this summer.

-- Edited by Kevin McIndoe

Simon Fasdal heads the fixed income trading desk at Saxo Bank. 
28 July
Juhani Huopainen Juhani Huopainen
Even if (and when) yields begin to rise, it is not bad news, if it will be because of higher growth- and inflation expectations, and not only solvency/liquidity-worries. JPM's classic chart on stock returns and yield levels is beautiful - rates rising from low levels are good for equity prices, up to a certain level. (Source: JPM's quarterly chartbook 'Guide to the markets', available on the web for free)
06 August
vagoramix vagoramix
Good Morning, Higher Yield for most of the bonds is here. We see a downfall of the bond prices all across the board, corporate bonds, emerging markets. Few categories have servived. Any idea why this is happening and how long is it going to last ?
06 August
Simon Fasdal Simon Fasdal
The Article is first of all a view on core yields (german/US), and the fear of rising core yield curves. With German 10Y today crossing all time low, i believe that the views reflects the present reality, where we see a sharp flight to safety move. However riskier assets, like High Yield Corporate Bonds and Emerging Markets is suffering in the present scenario, as well as equities. This is discussed closely in https://www.tradingfloor.com/posts/weekly-bond-update-markets-highly-resilient-1102388

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