Since the early 1980s gilt yields have generally always been higher than bund yields. Historically, the Bundesbank/ECB has been seen as having more inflation fighting credibility than the Bank of England, hence a lower inflation risk premium on bunds relative to gilts. Lower interest rates, lower inflation and a strong currency were the hallmarks of German monetary policy pre-EMU and German led monetary policy since 1999.
However, things are changing. Markets are reflecting the trend toward diminished German influence over monetary policy and, at the same time, greater credit risk for the key provider of sovereign bailout funds in the euro area. While the immediate trigger for the increase in German yields was a poor bond auction, German yields have been generally rising over the last month as systemic risks in the euro area have continued to rise and contagion of the sovereign debt crisis has spread to the core.
Markets take control
In a sense, by driving German yields higher the markets are trying to force a shift in the policy stance of the ECB. Many people believe the ECB has to follow the examples of the Federal Reserve and the Bank of England and engage in large scale asset purchases in order to effectively ease monetary policy and to cap the rise in borrowing costs for European governments. The issues around moral hazard and dilution of the ECB’s monetarist stance means there is intense opposition to such a policy shift within Germany.
Personally I don’t think there are significant inflation risks from the ECB agreeing to do QE. In fact, there are more inflation risks from a collapse of the euro as any scenario involving countries giving up on the single currency and re-introducing national currencies would involve big shifts in relative currency values and increased inflation in those that devalue versus the core.
The evidence from the UK and the US is that unconventional monetary policies have not had a significant impact on longer term inflationary expectations. Evidence suggests QE has not had a meaningful impact on inflationary expectations as measured by the bond markets. There is no reason to think that this would be any different in the euro area and, indeed, the deflationary risks are much greater as the area goes into an economic downturn.
ECB must act
Until the ECB relents or politicians can gather up all of their initiatives to date and package them in such a way that markets really believe enough has been done to prevent the insolvency of large parts of the euro area, bond yields are likely to continue to rise. Italian borrowing costs are through 7% as I write, despite the new technocratic government and Spanish yields have not benefited from the victory of the more reform-minded Partido Popular at the election two weeks ago. It is difficult to see any of this reversing permanently on anything other than the ECB being used as a lender of the last resort. All else, so far, has failed.
I’ve always tended to look on the positive side of the debt crisis in as much as something would eventually be done to prevent the euro breaking up. I doubt that I am alone in having my faith shaken in recent months. Also, I have always believed that the outcome to the crisis is somewhat binary – either the euro breaks up (and there are some horrendous implications of that happening) or Europe strives to achieve an even greater level of integration and centralisation of fiscal policy.
Uncertainty the biggest enemy
Yet as we head to the end of the year uncertainty is the biggest enemy of investors. Stock markets are well below last year’s levels, credit spreads are wider and volatility is up. Economic growth forecasts are being lowered all the time and the current crop of purchasing manager reports on industrial activity suggest that many economies – including Germany and China – are experiencing a drop in output. None of this is helping the mood and sentiment remains very, very poor.
Investors need politicians to take the necessary steps to allow their focus to shift back to generating returns because without growth we are facing a very bleak future. The frustrating thing is that we can see what needs to be done – in the US and the UK nominal GDP growth is fairly buoyant and bond yields are very low. Nominal GDP growth of 5-6% with government borrowing costs at 2-3% is the perfect recipe for positive debt dynamics. That is what we have in the US and UK while we have the reverse (or worse) in most of Europe.
If that doesn’t change, gilt yields below Germany might become the norm rather than the exception.
