In spite of trade-war driven volatility in May, market behaviour in many major regions during the second quarter was characterised by positive returns from both equities and bonds (with Japanese and other Asian equity weakness a notable exception):
We’ve discussed the theme of correlated bond and equity returns regularly over the last couple of years and won’t revisit at length here. However, there has been a shift in the nature of commentary over the last three months.
Specifically, rather than emphasising (as we have) the correlating role played by the global discount rate, discussions after May tended to focus exclusively on the prospects for more QE out of Europe as being the main driver of price action.
Aside from the behavioural nature of the language above (‘fear of missing out,’ ‘appeals to authority,’ the dual time horizons in ‘it will end in tears…but not for now’), these quotes reveal the extent to which European QE has come to the forefront of investor motivations in the last quarter.
When the consensus view seems so confident in its view of the future, it is normally a good sign that asset prices could be vulnerable to disappointment (especially when valuations leave little room for error), but are there any other observations we can make around these QE arguments?
A one way trade?
Talk of QE seems to have prompted the view that yields on European government bonds can only go in one direction. The periphery has been a notable beneficiary, with Italian government bond yields unwinding all the sell-off that came in the aftermath of last May’s political fears (albeit with spreads over bunds still somewhat elevated).
a) we should always beware of focusing on a single issue (e.g. internal Italian politics and budget negotiations) as the only one to worry about for asset prices, because other forces can always come along, and,
b) the attention paid by markets to news is not consistent.
Consider how yields may have reacted if the same Italian political news had taken place six months ago. Moreover, the attention given to an issue in market commentary is itself often a function of what asset prices do; if price responses are muted then it is often assumed that the issue is less important, conversely if they are large it often forms a self-reinforcing cycle of panic between price and news coverage.
Bond yields can rise while QE is going on, and can go lower when it stops. For example, QE does mean that there is a meaningful amount of Italian sovereign debt held by the ECB (around €365 billion), but there is still a huge stock of debt held by others (total outstanding is around €2,742 billion). If the collective beliefs of these investors change, then yields can move.
We can see this in a couple of simple examples.
1) European QE
In Italy, it appears as though yields fell ahead of the QE era and sold off once it came to an end:
Putting aside the argument that the initial decline was less about QE bond-buying itself and more about the ECB being prepared to act as a lender of last resort (‘whatever it takes’) – which can be said to amount to the same thing – it is worth noting that the QE era has seen losses in excess of 10% from Italian bonds on three occasions.
The first two of these reflected global fixed income trends (as reflected in the relationship with US Treasury yields), the second was the recent political scare.
It is also the case that the recent decline in Italian yields began after QE ended in December 2018, and before there was talk of more QE to come.
2) The US
In the case of the US, QE ended at the end of 2014 and yet yields are currently at levels not too far from the lows reached while bond purchases were taking place (in fact the recent lows in yield came in 2016).
Was this because of QE in other countries? Possibly, but even if this argument is true it only reinforces the sense that we should not look at ECB bond buying in isolation as the only potential driver of bond yields.
Much academic analysis suggests that QE does have the impact of depressing yields (though often by surprisingly modest amounts) but this is an ‘other things being equal’ impact. Other forces can clearly have an impact.
Many will predicate their case for owning bonds on such factors, the common today being cyclical concerns (there is certainly no sense that QE will be able to create inflation). However, while there are many reasons why you may want to hold low or even negative-yielding bonds, we should always be wary if that reason is simply the expectation that someone will buy it off us later, even if it is the Central Bank.