In Europe, investors like Alessandro Tentori are starting to say their goodbyes to the region’s bond market, worried that soon there may not be any place left for them.
Collapsing trading volumes are a worrying sign for the market’s future, the chief investment officer for Axa Investment Managers wrote in a recent note to clients titled “Bye Bye Bunds,” a reference to the German bonds that serve as the benchmark for Europe. The culprit? The European Central Bank, which this year has taken its purchases of debt to unprecedented levels. By the end of 2021, investors will be even more squeezed out.
The ECB, which added 500 billion euros ($606 billion) to its pandemic bond buying program Thursday, is set to own around 43% of Germany’s sovereign bond market by the end of next year and around two-fifths of Italian notes, according to Bloomberg Intelligence. That’s up from around 30% and 25% respectively at the end of 2019.
Trading volumes in bund futures have collapsed 62% since the ECB started buying bonds, according to Axa, while ranges -- the lifeblood of traders -- have nose-dived across Europe. In both the safest and riskiest nations, this quarter’s spread between the highest and lowest yields is the tightest it’s been since at least the global financial crisis.
Concern is growing that Europe’s bond markets are being “Japanified” -- effectively shut down by a single, dominant buyer. Even yields for nations that were nearly bankrupt less than a decade ago are rapidly descending toward 0%, the level at which investors can no longer expect to generate a return by simply holding a bond to maturity. Portugal’s 10-year yield fell below 0% for the first time this week, while Italy’s is less than 0.6%.
Tentori’s fear is that even after a deluge of coronavirus-fueled issuance this year, Europe’s debt markets are on the same road-to-nowhere as Japan, where the market has been gouged out by the nation’s central bank. He’s taken to carefully tracking liquidity, and is fearful that soon price discovery in Europe will effectively cease to exist once the pandemic fades.
“The issue with quantitative easing is that the bonds on the central bank balance sheet don’t trade,” he said. “The only way you can remove credit risk completely from European governments is either by full mutualization,” he said, referring to the sharing of national debt burdens at the wider EU level, which would require treaty changes or even referendums. “Or by shutting down the market.”
The implications are stark for bond traders. Japan’s fixed income trading floors have been decimated over the last decade and the markets are so dead that sometimes not a single government bond trades in a day. Despite the fact that there is over $8 trillion of Japanese debt in existence, the Bank of Japan owns around half of it, and sometimes close to 90% of individual issues.
Traders in Europe are now turning to the foreign-exchange market to make money and concerns are growing that investors are taking bigger risks elsewhere in markets to compensate.
Debt Deluge
When the ECB first started buying bonds in 2015 it was tied to strict purchase rules in an effort to avoid accusations of monetary financing. The central bank was allowed to buy no more than a third of a country’s bonds and had to weight purchases of euro-area member states by the size of the economy and population.
That all changed this year, when President Christine Lagarde scrapped those limits for the central bank’s pandemic purchase program, with another 1.85 trillion euros being pumped straight into bond markets, including the extra amount announced Thursday.
“Euro rates are in lockdown, not just for the winter, but also probably for all of 2021,” wrote Jamie Searle, a strategist at Citigroup Inc. in a recent note to clients. The ECB “won’t risk yields rising on either bad news (fragmentation) or good news (vaccine): this is what yield curve control looks like,” he said.
Central banks’ own research departments regularly produce work showing QE has stabilized markets, boosted growth and driven faster inflation. Outside though, there’s far less certainty that those benefits will persist after years of monetary stimulus following the global financial crisis more than a decade ago.
Japan was the pioneer of QE in an attempt to recover from the nation’s “lost decade” at the start of the millennium. The BOJ ended up devouring the country’s bonds through its quantitative easing program, effectively financing the bulk of government spending since Prime Minister Shinzo Abe took office in December 2012. Yield curve control -- whereby rates on bonds are tethered to a particular level -- was introduced in 2016.
The death of bond volatility in Japan is the byproduct of a failed attempt to revive inflation and growth against a backdrop of technological changes and an aging population.
Despite the euro area having 19 national bond markets compared with one for Japan, the region is widely seen as already being trapped by Japanification. The entirety of Germany’s yield curve is submerged below 0%, while investors in the near-junk bonds of nations hit hardest by the sovereign debt crisis have also seen potential returns eroded.
The U.S., while further behind, may not be immune either. The ICE BofA MOVE index, a gauge of price swings in the $20 trillion Treasury market, is close to record lows amid speculation that the Federal Reserve will aim to drive down longer-term borrowing costs through its own bond-buying program. That package isn’t beholden to any limits.
To be sure, trading floors in the euro area have been busy this year thanks to a flood of new debt -- especially via highly-profitable bank syndications. Average daily volumes in European bonds climbed 23% in November compared with a year earlier, according to TradeWeb Markets Inc. data. But much of that is just a function of the supply and of the ECB encroaching further into markets. As borrowing drops off in the wake of the crisis, the fear is that trading will too.
“I’m not sure there is a motivation to squeeze bond investors out completely and into other markets, although that will logically happen in QE,” said Richard Gustard, head of EMEA securities trading at JPMorgan Chase & Co. “There’s been a transfer of ownership between the private sector to the public sector of bonds.”
Global Pandemic
The only real hope for volatility returning in the fixed-income market is if central banks are able to pull back. But since the financial crisis it has been a one-way street. Turnover in German bonds hit the lowest level since at least 2005 in the second half of last year, according to data from the Association for Financial Markets in Europe -- and that was before the most recent bond-buying spree.
And with inflation showing few signs of a rebound, the ECB’s distortive effect on the market is likely here to stay, irrespective of what happens to the region’s economy and politics in the wake of the pandemic. For market professionals, there is a feeling that bond trading changed forever in 2020, and not for the better.
“Nothing is so permanent as a temporary government bond program,” said ABN Amro’s head of bond trading Nils Kostense, a play on an iconic remark about fiscal expenditure from the economist Milton Friedman. “I don’t see that going away too easily.”
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