Article / 26 July 2017 at 10:00 GMT

Weekly Bond Update: Draghi slowly makes haste in normalising rates

Fixed Income trader / Saxo Bank
Denmark
  • European government bond yields are jumping in anticipation of ECB policy reversal
  • But last week's ECB meeting failed to confirm that as Draghi was unmoved
  • Post-crisis normalised yield level is probably 150-250 bps away from current market
  • Draghi will need to walk a tight rope when he speaks on Aug 24 in Jackson Hole

ECB president Mario Draghi
 ECB president Mario Draghi did not deliver an awaited reversal of policy at the 
bank's meeting last week. Image: ECB webcast

By Michael Boye

Following several "cry wolf" moments, yields on European government bonds are finally starting to shoot higher in anticipation of the pending reversal of years-long accommodating monetary policies of the European Central Bank.

However, last week's ECB policy meeting failed to confirm these suspicions, as president Mario Draghi (once again) fell back to his familiar balanced position (some would say dovish) and enigmatic attitude. Investors were warned before the news conference, when the initial policy release contained no change in language, whereas many commentators had seen a tightening in acknowledgment of the progress in the European economy

The 10-year German government yield has spiked in recent weeks in anticipation of an upcoming change in policy at the ECB.
Germany
Source: Bloomberg

In reality, though, investors should have been distrustful far earlier, as the sudden change in sentiment, which saw the benchmark 10-year German yield jump from 24 basis points on June 26 to 60 bps on July 13, had seen very little firm backing from other ECB committee members. On the contrary, after Draghi's eye-catching "reflationary forces" remarks — almost carelessly delivered during an investors' forum in the Portuguese town of Sintra — the central bank rushed to let the market know that it had "misjudged" the comments.

For the markets it seemed as if the genie was out of the bottle, and there was no way back. What is obviously underpinning volatility is that even though a post-crisis normalised yield level may be lower than historic levels, it is still probably in the region of 150-250 bps away from where the current market is pricing. Clearly, the slightest increased chance of that journey beginning, and the recent move higher in market yields would only look like a canary in the coal mine.

For the ECB this precarious situation highlights the immense communication challenge it faces when addressing markets in the near future. In this light, Draghi's upcoming appearance at the Fed's Jackson Hole economic policy symposium on August 24 will be an intriguing one for bond investors as he will have to walk a tight rope to avoid setting government bond markets on fire. For most bond investors Jackson Hole immediately resembles Ben Bernanke's famous indication of the end of the Federal Reserve's quantitative easing bond buying programme in 2013. US 10-year Treasury yields, which were trading at 1.50% at the time, surged above the 3% mark before year-end, and investors are now vary of a similar message (and market reaction) from the European counterpart.

When then-chairman Ben Bernanke signalled the end of QE at Jackson Hole in 2013, treasury yields jumped in response.
Bernanke
Source: Bloomberg

Already before last week's policy meeting, several analysts were calling for the ECB to further taper its bond buying to €40 billion a month, down from €60 billion currently and from €80 billion a month originally. By now, though, this estimate has probably been pushed back to October at the earliest, all the while the balance sheet of the Frankfurt-based bank continues to swell and recently surpassed the size of Japan's economy.

Despite the potential pending change in monetary policy, the music is still playing in European government debt markets, as indicated by peripheral spreads nearing record-tight levels again. Spain's spread to German 10-year yields is just 5 bps shy of reaching a new post-2010 low, while the political uncertainty that saw the French spread trade close to 100 bps earlier this year has vanished entirely, and the French spread is now completely back on par with historic levels. Portugal is the new top boy of the region, and Greece is allegedly considering taking advantage of the lowest government yields since 2009 to sell new debt in the market.

Spread between Spanish and German debt is nearing the lowest level since the Eurozone debt crisis erupted in 2010.
Spain

Source: Bloomberg

For now and in the short term, complacency seems to rule, and investors worry more about securing their sun beds and sun tans than the direction of monetary policy. But come August 24 and it could be a rude awakening for bond investors, as Draghi will define his own Jackson Hole moment and potentially break with years of monetary policy stability.


Buffalo near Jackson Hole
 "Oh give me a home where the central bankers roam ..." Buffalo grazing under the 
Grand Teton Peaks near Jackson Hole, Wyoming. Photo: Shutterstock


– Edited by John Acher

Michael Boye is a fixed income trader at Saxo Bank.

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