In last week’s article, I documented the weak start to the year for the US equity market with the S&P 500 index declining by 5.3 per cent after first dropping into ‘correction’ territory and then recovering during the last two days of January.
The sovereign bond markets in the US, UK and the eurozone also performed poorly since the start of the year as it became clearer that the major central banks will be tightening monetary policy following the spike in inflation. As a result, bond yields rallied to their highest levels in many years.
The Federal Reserve indicated its intent to raise interest rates next month following a rapid rise in inflation to 7.5 per cent in January, which was the strongest reading since February 1982. The chairman of the Federal Reserve recently also refused to rule out an aggressive sequence of increases to follow the initial rate hike in March. Markets are now expecting five interest rate hikes of 0.25 per cent each during the course of 2022, with some economists also suggesting up to seven or even eight rate hikes to combat the prevailing stubbornly high inflation.
Across the eurozone, the major movement in yields took place on February 3 when during the press conference following the monetary policy meeting of the European Central Bank, president Christine Lagarde acknowledged that the inflationary situation has changed dramatically following a record high reading of 5.1 per cent for the month of January. This was interpreted by the markets that the ECB was not ruling out interest rate hikes this year, which would imply an end to the quantitative easing programme much earlier than expected.
The ECB has been buying around €80 billion worth of bonds per month throughout the pandemic. This was expected to
reduce to €40 billion per month as from April 2022, €30 billion as from June 2022, and reach an open-ended commitment of €20 billion in September 2022.
In fact, money markets priced in a very strong probability of an increase of 10 basis points in the ECB’s deposit facility rate by June 2022 and more than 40 basis points in interest rate hikes by the end of 2022. If this were to take place, it would be the first interest rate hike by the ECB since 2011. The ECB’s deposit facility rate has been stuck at -0.5 per cent since 2019 and has been below zero since 2013.
The benchmark sovereign bond across the eurozone is that of Germany. The yield on the 10-year German bund rose to +0.30 per cent on February 11 (the highest level since early December 2018), representing a strong recovery from the level of -0.4 per cent only two months ago. In Italy, the 10-year bond yield jumped to just under two per cent, the highest since May 2020, compared to the all-time low of 0.43 per cent recorded this time last year. All euro area bonds with maturities of five years and longer now carry positive yields compared to the situation when all short- to medium-term euro sovereign bonds were in negative territory during the worst months of the pandemic.
A few days after the February 3 monetary policy meeting, the president of the Dutch Central Bank and a member of the European Central Bank’s Governing Council commented that he expects the ECB to raise interest rates during the fourth quarter of this year. He also argued in favour of winding down the central bank’s asset purchasing programme as quickly as possible.
Despite further comments by ECB president Christine Lagarde on February 7 that there is no need for large-scale monetary policy tightening in the eurozone as inflation is set to fall back and could stabilise around two per cent, yields continued to move higher. Last week, the yield on the 10-year German bund continued to rise to over a three-year high of +0.3 per cent. Moreover, the ECB’s chief economist Philip Lane also opined that eurozone inflation will come down “without a need for a significant adjustment in monetary policy”.
The ECB president continued to downplay expectations late last week when she explained that the bank will not rush into raising interest rates and will pursue any policy tightening slowly. Lagarde was quoted as having said that “if we acted too hastily now, the recovery of our economies could be considerably weaker and jobs would be jeopardised”.
As explained in several of my articles in the past, there is a clear correlation between movements in yields across the eurozone and those of Malta Government Stocks. The sharp upward movement in yields over recent weeks was also reflected in Malta as the Central Bank of Malta revised MGS prices downwards in a consistent manner over the past two weeks.
The yield on the 10-year MGS moved up to 1.36 per cent compared to a level of 0.80 per cent at the start of the year. Similarly, the yield on the longer-dated MGSs also moved sharply higher with a corresponding sharp decline in MGS prices. Few investors may realise the actual extent of the declines in prices in such a short period of time. It is worth highlighting that all MGSs maturing from 2031 onwards dropped in excess of six percentage points since the start of the year, with the main declines happening since early February. For example, the price of the 5.2% MGS 2031 dropped from 141.86 per cent (as at the end of 2021) to 135.33 per cent and the 3% MGS 2040 saw its price decline from 126.61 per cent (also as at the end of 2021) to just over 118 per cent. This would represent a sharp diminution in value for those investors holding sizeable holdings of such securities within their investment portfolios.
It is also interesting to note that the prices of the MGSs issued over the past two years have recently all dropped to below their par value (100 per cent), with the longest-dated bond, for example, (the 1.80% MGS 2051) sliding to 90.58 per cent.
Incidentally, last week, the Treasury of Malta announced the issue of €140 million in new MGS subject to an overallotment option of an additional sum of up to a maximum of €100 million. Yet again, these are directed at institutional investors and the three bonds have five-year, 10-year and 30-year maturities. Given the significant movements in yields over recent weeks, it will be interesting to gauge the appetite and pricing in the upcoming auction process.
Following the major developments over recent weeks that led to sharp declines across sovereign bonds, including those in Malta, investors’ attention is now very much set on the upcoming meeting of the ECB on March 10, where a clearer indication of the winding down of the QE programme would be expected as the central bank is expected to update its economic forecasts for the next two years. The statements made by the ECB officials and the economic data being published should lead to continued volatility across the bond markets.
It is inevitable though that with the era of ultra-loose monetary policy measures coming to an end, yields need to correct, reflecting the new inflationary environment we are witnessing.