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FOR PROFESSIONAL INVESTORS
Making Sense of the Selloff
Steven Friedman, Director, Central Banks & Official Institutions
Cedric Scholtes, Head of Global Rates & US TIPS Portfolios
May 2015
The early stages of quantitative easing (QE) in developed markets
tend to be associated with currency depreciation, lower long-term
rates driven by a collapse in the real term premium, and a rally
in risk assets. As discussed in a recent weekly commentary, the
ECB’s January QE announcement led to market effects that were
consistent with, and in some respects stronger than, the QE
experience elsewhere. But to the likely dismay of ECB policy makers,
much of these effects have reversed over the past three weeks,
as the euro strengthened six percent against the dollar, the Euro
Stoxx index declined close to seven percent, and 10-year sovereign
bond yields rose to levels last seen in December. Overall, financial
conditions in Europe today are now only marginally easier than
they were at the time of the ECB’s QE announcement in January.
In our view, the reversal of QE trades is largely a positioning
adjustment from stretched valuations, and has very little to do
with any fundamental change in Europe’s macroeconomic outlook
or the ECB’s commitment to QE. As such, and putting aside for a
moment the risks related to Greece, we expect European yields
to stabilize around current levels given our skepticism that ECB
QE will radically shift the European growth and inflation outlook
absent more aggressive structural reforms and pro-growth fiscal
policy.
INFLATION BOOST - MISSION ACCOMPLISHED?
QE works in part by driving down real rates of return on sovereign
debt, leading investors to seek higher returns on other assets.
However in its early stages QE tends to lower nominal yields as
well, because the decline in real rates offsets any increase in
inflation compensation. Over time, if the public believes that QE
is leading to a sustainable shift in the inflation outlook, the rise in
inflation expectations would feed through to higher nominal yields.
With this framework in mind, one critical observation from the sharp
rise in European nominal yields since mid-April is that 10-year
Eurozone inflation swap rates have increased only modestly over
the same time period, implying that real yields have risen sharply.
In addition, survey-based measures of inflation expectations have
not increased significantly since the launch of ECB QE. The ECB’s
own Survey of Professional Forecasters saw median expectations
for year-end 2017 inflation rise to just 1.6 percent in the most
recent survey, up from 1.4 percent in the survey conducted during
the fourth quarter of last year. These relatively modest moves
in market-based measures of inflation compensation as well as
survey data indicate that the rise in European sovereign yields has
not been driven by conviction that QE has prompted a regime shift
in the inflation outlook. Declines in European stock markets also
suggest that the rise in yields is not due to an increasingly positive
outlook for growth and inflation.
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Making Sense of the Selloff | May 2015 - 2
LACK OF ECB COMMITMENT?
Some market commentators suggest that growing concern that
the ECB will not complete its announced purchases contributed to
the rise in Eurozone yields and the broad tightening of financial
conditions. This concern could stem from a perceived lack of
commitment to the program among Governing Council members,
or if the Council had significantly upgraded its inflation outlook
such that an early end to asset purchases would be warranted.
We view these explanations as extremely suspect. In his last postmeeting press conference, President Draghi made clear that not
only does the ECB intend to complete its announced purchases, but
that purchases could extend beyond September 2016 if inflation
is not on a sustainable path to the ECB’s target. Comments from
other Governing Council members have been consistent with this
message. In addition, growth and inflation data in the Eurozone
have not materially improved to the extent that Council members
would contemplate an early end to asset purchases. In fact, Council
members are fully aware that other central banks, particularly
the Federal Reserve, ended early rounds of QE prematurely and
damaged economic prospects. The ECB likely understands this key
lesson from the international experience, and that any signal of
an early end to purchases would only jeopardize the attainment of
their policy objectives through a tightening of financial conditions.
a sharp move in rates. Still, investors have long understood
that the supply calendar net of QE was set to ramp up, and
swing from roughly -$40 billion euro in net issuance in
April to a similar but positive figure in May. As forthcoming
supply increases can lead to a price concession, some shortterm investors likely decided to reduce long positions in
advance of new issuance. On the margins, a few “surprises”
in net supply may have also affected market sentiment.
These include the growing awareness that some sovereigns
may take advantage of low rates to term out the maturity of
forthcoming new issues, or the realization that a number of the
national central banks (and the Bundesbank and the Banque
de France in particular), have made QE purchases at shorter
average maturities than the average maturity of their national
bond markets. Both of these net supply “surprises” add more
duration to the market than investors otherwise expected,
and increase the risk premium for holding sovereign bonds.
•
Systematic hedge funds and other investors that employ
momentum strategies likely suffered sizeable losses as rates
began to rise, and were forced to unwind positions to preserve
capital. These strategies often use leverage, which implies the
potential for significant drawdowns if positions are not quickly
reduced. Other investors, even if not engaged in leveraged or
systematic strategies, may also have quickly reduced positions
as the move higher in yields gained momentum. This could have
occurred due to VaR breaches or an increase in bond price and
equity correlations, which may have led some investors to reduce
long bond positions that had been used to hedge equity holdings.
•
We have previously mentioned that the -20 basis point floor
on ECB bond purchases contributed to the sharp decline in
long-term sovereign yields and significant curve flattening.
As yields on shorter-dated securities approached the floor,
investors came to expect that the Eurosystem would need to
shift purchases further out the yield curve. Unfortunately, the
same dynamic works in reverse. The recent rise in shorterdated yields frees up more securities for Eurosystem purchases,
and reduces the likelihood that purchases will have to extend
further out the curve. For example while three weeks ago bunds
out to 4 years maturity were trading at or below the -20 basis
point floor, now bunds with maturities beyond two years are
trading above the floor and eligible for purchase. This implies
potentially less duration removed from the market via central
bank purchases. This dynamic feature of the ECB’s program is
quite different from other QE programs, where movements in
yields did not imply self-reinforcing shifts in the composition of
central bank purchases.
STRETCHED VALUATIONS AND CROWDED POSITIONING
While we believe that the Eurozone was the catalyst behind the
sharp increase in developed market bond yields, our explanation
tends more towards a sharp unwind of QE trades once bond yields
fell well below fair value metrics, with crowded positioning and
other market dynamics amplifying the move. While it is difficult
to identify a specific catalyst for the unwind, one possibility is
that public comments by some fund managers about stretched
valuations led other investors to take profits as core Eurozone
sovereign yields fell close to or further into negative territory. The
following factors also likely contributed to the decision to pare long
positions in Eurozone sovereign bonds, or to the severity of the
move once yields began to rise:
•
The approximately 20 percent increase in front-month Brent
crude oil futures prices since mid-March contributed to an
increase in Eurozone inflation compensation and reduced the
probability that bond investors attached to further declines in
long-term yields. This less attractive risk-return tradeoff led
to position unwinds, and the higher yields served as a catalyst
for euro appreciation and pressure on risk asset prices.
•
Investors and traders keep close tabs on sovereign debt
supply calendars, so absent any surprises in issuance, supply
considerations would not serve as a strong catalyst for such
FOR PROFESSIONAL INVESTORS
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Making Sense of the Selloff | May 2015 - 3
WHAT HAPPENS NEXT?
As noted above, we do not view the rise in Eurozone spot and
forward yields as reflecting broad-based conviction that ECB QE
will succeed in reflating the Eurozone economy. Survey-based
measures of inflation expectations show little confidence that
inflation will return to the ECB’s target by the end of 2015, and
we generally share this skepticism. In the years ahead, aggregate
fiscal policy will remain tight as many sovereigns must still engage
in significant deleveraging. And progress on structural reforms in
some peripheral countries has been slow. In addition, it will be
difficult for inflation to move considerably higher over the next two
years as the Eurozone’s negative output gap will persist over this
time period. Global inflation pressures also remain muted given
growth below potential in many large economies including China,
an important Eurozone trading partner.
sheet policy that add duration to the market after liftoff could also
begin to pressure term premia later this year. Finally, and while
certainly not our central scenario, any communications error by the
ECB that appeared to lessen the commitment to QE would also risk
a move to much higher rates.
Against this backdrop, we see little reason to expect the recent selloff in Eurozone sovereign bond markets to continue. While there is
a range of views across the investment team, we benchmark our
expectations for the average ECB policy rate over the next decade
at roughly 75 basis points. Assuming the ECB continues to engage
in financial repression for several years through a mix of QE and
forward guidance, it is not unreasonable to suspect that the term
premium will remain close to or even below zero for the foreseeable
future. This would benchmark fair value on the 10-year bund yield
at 75 basis points, compared to the current level of 65 basis points.
In forward space, where yields should be tied to trend nominal
growth expectations, valuations appear a bit more stretched even
after the recent sell-off. Assuming trend Eurozone real growth of
1.0 percent and inflation of 1.5 percent, the current nominal 5y5y
bund yield of one percent remains well below long-run equilibrium.
But since this is precisely the intention of unconventional policy,
low forward rates can persist absent a change in the growth and
inflation outlook or a shift in the ECB’s policy reaction function. We
also cannot dismiss the possibility that low forward rates in the
Eurozone reflect expectations that the ECB will struggle to achieve
its inflation target over the long term.
To summarize, the combination of deleveraging, low levels of
domestic and global inflation, and aggressive use of unconventional
policies should continue to suppress Eurozone sovereign yields. Still,
we need to be attentive to factors that could lead to further sharp
increases in yields. One important factor would be a continued rise
in oil prices, particularly if driven by a pickup in global demand,
as this would lead to higher inflation expectations. In addition, the
approach of policy liftoff in the United States will initially increase
market uncertainty and lead to higher term premia across sovereign
bond markets. Potential changes to the Federal Reserve’s balance
FOR PROFESSIONAL INVESTORS
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Making Sense of the Selloff | May 2015 - 4
BIOGRAPHIES
Steven Friedman
Director, Official Institutions
FFTW
Steven is a member of the Central Banks and
Official Institutions team responsible for client
service and business development. He joined
FFTW in 2013 and is based in New York.
Before joining FFTW, Steven held various positions within the
Markets Group at the Federal Reserve Bank of New York, most
recently as Director of Market Analysis, where his work focused on
assessing market expectations for monetary policy. Prior to that,
Steven worked as Director of Foreign Exchange and Investments,
where he had oversight for the Federal Reserve’s and Treasury’s
foreign exchange portfolios. During the financial crisis, he worked
on the design and implementation of a number of liquidity
facilities, such as swap lines with other central banks, agency debt
purchases and the commercial paper funding facility. Steven also
spent two years at the Bank for International Settlements as a
member of the Basel Committee Secretariat. He has over 16 years
of market related experience.
Steven holds a BA in government and Russian studies from
Wesleyan University (1993), an MA in international relations from
The Paul H. Nitze School of Advanced International Studies at The
Johns Hopkins University (1998), and an MBA (executive program)
from Columbia Business School (2011).
Cedric Scholtes
Head of Global Rates & Head of US TIPS Portfolios
FFTW
Cedric is Head of Global Rates and Head of US
TIPS Portfolios at FFTW. He is responsible for
the overall performance of the Global Rates
team, implementing and improving investment
processes for this team as well as managing the
dedicated interest rate specialists who comprise the team. He also
has responsibility for overseeing US inflation-linked portfolios as
well as US government portfolios, including generating alpha ideas
within US rates and inflation markets for implementation across
applicable portfolios. Cedric joined FFTW in June 2006 as a portfolio
manager and is based in New York.
Cedric joined the firm from the Treasury trading desk at Goldman
Sachs, where his responsibilities included taking proprietary
positions and market-making in index-linked markets, as well as
enhancing the desk’s analytical capabilities. Prior to working at
Goldman Sachs, Cedric spent five years at the Bank of England, two
of which were spent on secondment to the Federal Reserve Bank
of New York. At the Bank of England, Cedric spent two years in
the Foreign Exchange Division, helping to manage the UK Treasury’s
foreign exchange reserves. Prior to that, he worked as a research
economist within the Monetary Analysis Division, researching
fixed income markets. Cedric has published articles on nominal
and inflation-linked debt markets in Bank of England, BIS and IMF
periodicals, as well as RiskBooks. Cedric has 15 years of investment
experience.
Cedric holds an MSc in finance and economics from Warwick
Business School (1999), an MSc in economics from the London
School of Economics (1997), and an MA/BA in economics from
Cambridge University (1996).
FOR PROFESSIONAL INVESTORS
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Making Sense of the Selloff | May 2015 - 5
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FOR PROFESSIONAL INVESTORS