As highlighted in last week’s article, the euro has weakened by 8% against the US dollar since June 2021, amid expectations of monetary policy tightening measures by the Federal Reserve which helped the dollar strengthen to a 16-month high against the euro. On the other hand, there have been conflicting views on similar tightening measures by the European Central Bank, which was one of the reasons for the weakness in the single currency.
Interest rate expectations not only affect the value of a currency but also hugely impact the bond market, with sovereign yields often moving in tandem with indications of movements in interest rates among other factors.
This is very evident from the changes in eurozone sovereign yields over the past 18 months. At the start of the pandemic in March 2020, the 10-year Germany yield had dropped to an all-time low of -0.91%, and after fluctuating wildly until November 2020, the benchmark yield strengthened significantly and approached the zero level again by mid-May 2021. However, it then moved back to around -0.50% by mid-August 2021, followed by a further rally towards -0.10% - but suffered a sharp drop once again in recent days.
Maltese investors with exposures across the local sovereign and corporate bond markets need to monitor movements in eurozone yields, since the prices published by the Central Bank of Malta on a daily basis for Malta Government Stocks are based on yield movements across the eurozone. Additionally, MGS prices and yields are important benchmarks for the pricing of corporate bonds and also for equities since valuation methodologies are very sensitive to the ‘risk-free’ rate (typically the benchmark sovereign 10-year yield).
The significant movements in yields across the eurozone, which are reflected in Malta, is very clearly depicted by tracking the movements in prices of some of the individual Malta Government Stocks.
By way of example, the 1.5% MGS 2045 (I), which had been issued by the Treasury just before the pandemic in early 2020, had been priced at 112.72% during the auction process. The price of this 25-year MGS had then spectacularly sunk to a price of 95% by mid-June 2020 (representing a decline of 17 percentage points in just four months) but recovered to the 99% level in early August 2020.
After easing back towards the 96% level by the end of August 2020, the price of the 25-year MGS rallied to 110% by mid-January 2021 before sliding back to 97% by mid-October 2021. Following the recent downturn in eurozone yields over the past few days, the price recovered slightly towards the par value of 100%.
These sharp price swings by the 25-year MGS over the past 18 months provide ample evidence of the price risk faced by investors when opting for exposure to long-term MGS at a time of historically low interest rates and expectations of potential rate hikes ahead in view of elevated inflationary pressures.
The movements in yields over recent months not only reflected the reopening of economies across the eurozone from the restrictive measures during COVID-19 but also expectations of tightening monetary policy conditions as inflation began to surge.
Many financial commentators and banking officials have been advocating that the European Central Bank (ECB) must also adopt tightening measures similar to the measures being contemplated by the US Federal Reserve.
The international financial media gave ample coverage to the comments made by Deutsche Bank CEO Christian Sewing last week. Sewing urged the ECB to tighten monetary policy to provide “countermeasures” against surging inflation, which he warned was producing risky side effects and would last longer than policymakers expected. Sewing added that “the consequences of this ultra-loose monetary policy will become increasingly difficult to fix the longer central banks fail to take countermeasures”.
However, in a speech delivered last Friday, ECB president Christine Lagarde reiterated that the “conditions to raise rates are very unlikely to be satisfied next year”. While Lagarde acknowledged that the current high level of inflation (at a 13-year high of 4.1% in October 2021) is likely to increase further by the end of the year, she argued that before taking any monetary policy decisions, one needs to identify the “underlying drivers of inflation”.
Lagarde argued that even though the ECB was taking concerns about rising inflation seriously, the drivers of these pricing pressures were likely to “fade over the medium term, which is the horizon that matters for monetary policy”. She added that in order for inflation to return to the ECB’s 2% target, the central bank needed to be “persistent” in its monetary policy. She warned that the ECB “must not rush into a premature tightening” of monetary policy, and before raising rates, there needs to be a “high degree of confidence that underlying inflation dynamics have genuinely improved”.
Following this very clear guidance from Lagarde, the euro weakened further against the US dollar and sovereign yields declined once again, thereby leading to higher bond prices.
The insistence by the ECB head against adopting interest rate hikes during the course of 2022 could limit further gains in eurozone yields despite escalating inflationary pressures. This ought to provide additional support to the local corporate bond market at a time when an increasing amount of issuance is taking place. Following the sizeable bond issue by GO plc earlier this year and the more recent issues by Mizzi Organisation Finance plc as well as Central Business Centres plc, International Hotel Investments plc is currently in the midst of the largest-ever corporate bond offering in Malta (together with the debt funding issued by Hili Finance Company plc in July 2019, also of €80 million). Moreover, another two bonds issues are imminent, with recent statements made by AX Real Estate plc and GAP Group plc.
The heightened demand by the retail investing public for most of the new corporate bonds launched this year is another sign that the capital market is becoming an increasingly important avenue to assist investors generate a positive return on their high levels of accumulated savings across the local banking system.
The capital market is becoming an increasingly important avenue to assist investors generate a positive return on their high levels of accumulated savings
The measures being introduced by several banks to dissuade customers from maintaining very high levels of excess cash in deposit accounts in view of the negative interest rate environment could channel largish amounts of liquidity into the capital market primarily into corporate bonds. This could continue to encourage Maltese companies to make increased use of the bond market for their funding requirements as a way of diversifying their sources of funding.
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