Bond yields trapped by interplay of economic and political news
November saw bond and currency markets driven by a mix of economic news and political risks. While reports from the business front were mostly positive—in particular in continental Europe—political events spoiled risk appetites. The week ending Nov. 24 saw the release of purchasing manager index data for the Eurozone, which had risen to its highest level in more than 6 years, confirming the European Central Bank’s assessment of strong economic growth. At the same time, the Ifo Institute’s business climate index indicated that company bosses in Germany—Europe’s largest economy—remained optimistic about the future.
All this was considered good news for the euro, and the single currency gained 1.3% against the USD during that week. The government bond market, on the other hand, hardly budged, with the 10-year Bund rate trading flat over the same period. Normally, one would have expected yields to go up, as risk appetite increases and investors shift their funds from safe sovereign issues to more volatile assets. But fixed income traders were still digesting the news from the previous weekend that coalition between Chancellor Angela Merkel’s Christian Democratic Union and the Free Democratic and Green parties had broken down, thus dramatically increasing chances of new elections in Germany.
Meanwhile, the 10-year US Treasury also seemed to be trapped in a relatively narrow range of 10 basis points. While a recent increase in personal consumption expenditures was considered good news, long-term yields had been held down by concerns about persistently weak consumer price growth and the slow progress of the promised tax reform. Ongoing allegations against former White House aides regarding connections to Russia during the 2016 presidential election added further downward pressure.
Action by the Federal Reserve Bank, on the other hand, helped lift the shorter end of the curve, and the monetary policy-sensitive 2-year increased by almost 20 basis points over the course of November. This resulted in the flattest US government yield curve in more than a decade, as measured by the spread between the 10-year and 2-year points.
From a portfolio perspective, this had interesting consequences for the risk decomposition across asset classes, as well as overall diversification. As we noted in our recent stress-testing study on the Bank of England rate hike in November To Hike or Not to Hike, the positive relationship between stock markets and interest rates seems to be much stronger at the short end of the curve than with the longer-dated instruments. Thus, we could have positive returns for long-term government bonds (as yields were depressed by political risk and low inflation expectations), while equity indices posted yet more record highs. For most of this year, stock and bond returns have been negatively correlated, so that the latter provided crucial risk reduction benefits in Axioma’s global multi-asset class model portfolio. When this was not the case, overall portfolio volatility could be expected to increase.
Another important source of diversification in the model portfolio has been the negative interaction between equity and FX returns (as stock markets went up, foreign currencies depreciated against the USD). This was still the case in the first half of November, and the euro in particular helped actively reduce portfolio volatility. However, this relationship has become less pronounced, which again led to slightly higher overall risk.