The major talking point in European Investment Grade Fixed Income markets last week was the sudden and violent widening of non-core markets against Germany. It was most evident in France, but also occurred in Italy, Portugal and Greece (the latter for very idiosyncratic reasons to be fair). The primary cause of the widening was the dramatic fall in popularity of the Conservative candidate Mr Francois Fillon, caused by a scandal about alleged payments to his wife. Having been the clear favourite, Mr Fillon saw his popularity plummet, with some commentators calling for his withdrawal from the race. In theory, that would leave the way clear for independent candidate Emmanuel Macron to face the National Front’s Marine Le Pen in the second round head-to-head poll on 7 April. The sudden bout of nervousness around French government bonds is a little surprising, since the polls have consistently predicted Mrs Le Pen would advance to the second round, but be defeated in that second round, no matter whether she faced Mr Fillon or Mr Macron.
Perhaps there was some fears that a left-wing alliance of Mr Hamon and Mr Melenchon would be enough to defeat both Mr Fillon and Mr Macron, leaving the decision between a far-right and a far-left candidate. Whilst Mrs Le Pen has softened her public stance in recent weeks, her manifesto is still anti-EU and anti-Euro, and this continues to worry the markets. Most commentators believe that even if Mrs Le Pen were to win the Presidential election, the National Front are unlikely to gain enough seats in June’s legislative elections to be able to push through a referendum on Eurozone membership. What’s also interesting is that sovereign French bonds bore the brunt of the damage – French credit and equities underperformed a bit but nothing like the damage that French government bonds suffered. Another potential explanation for the selling is Japanese investors (who have traditionally been big fans of French sovereign bonds) are concerned about the political risks, and selling their holdings. To us, the reaction last week was probably overdone, but there are likely to be further periods of volatility in the next two months before the election. Although current levels on French OAT’s are attractive, we can take our time entering overweight positions.
2. Bond Bear Markets – A History
One of the other blog sites that we like to keep an eye on is called “Bank Underground” – a blog for Bank of England staff “to share views that challenge – or support – prevailing policy orthodoxies”. In early January 2017, Paul Schmelzing, a visiting scholar from Harvard University where he concentrates on 20th century financial history, published a guest blog. It was a fascinating review of the current bond market in the context of nearly 800 years of economic history. Schmelzing finds that the current bond bull market (in its 36th year) is, as many of us thought, one of the largest ever recorded. Only two previous episodes (a 15th century rally and another rally that started in 1559) recorded longer continued risk-free rate compressions. But the really interesting part of the blog is when Schmelzing analyses 12 modern “bond shock” years, which he characterises as periods when long-term bond creditors lost more than 15% in real price terms. On average, in these periods, Consumer Price Inflation (CPI) averaged 6.1%, global growth was below average but not in recession and U.S. federal deficits were only 2.3%. Three types of bond bear markets were identified:
- Inflation Reversal – a sharp turnaround in realised CPI, link what happened in the U.S. from 1965 to 1970
- Sharp Reversal – characterised by steep but short-lived turbulence associated with financial sector leverage and positioning, most notably seen in 1994
- Value at Risk (VaR) shock – seen in Japan in 2003 when the Japanese Government Bond curve steepened dramatically
Schmelzing thinks that a 1994-type crash is unlikely, given the recent focus on bank leverage regulations, but that some combination of Type-1 and Type-3 bear markets are more likely. As we have mentioned many times in the past in this blog, inflation dynamics are picking up at a time when central bankers appear willing to allow economies to “run hot” and to tolerate inflation overshoots. Schmelzing suggests this could cause “sustained double-digit losses on bond holdings”, we think that’s probably too pessimistic. But we do think 2017 is a year when the pressure will be for higher bond yields, and a short duration bias is our general default position within sovereign bond markets.