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John Chatfeild-Roberts: Yield trip full of surprises

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Bond yields have been plummeting amid expectations that Mario Draghi, president of the European Central Bank, would intervene in the market to counteract the potential for deflation and stimulate the region’s stagnating economic growth. Those expectations were met last week. 

Even so, the strength of government bond markets has surprised many commentators this year. UK, US and European sovereign bonds have all appreciated consistently. After poor first-quarter US GDP growth, which has been widely deemed to be weather-related, economic data in the UK and US has appeared to be on an improving trend, calling into question the paradox of rising government bond prices (and falling yields) while the spectre of interest rate hikes grows.

In our view, a number of economic and technical factors could be to blame: uncertainty on the growth trajectory, deflationary forces at work or simply the lack of high-quality collateral driving prices up. Another factor could be the relationship between European and UK or US bond yields.

Benchmark

For many years, the US Treasury bond has been the benchmark against which all other risk assets are priced – a promise of payment from the government of the largest economy in the world with the sole power to print US dollars to pay its bondholders in extremis.

Why then are the yields on previously deemed speculative bonds issued by Ireland, Italy and Spain within spitting distance of US Treasuries while Dutch, French and German bond yields are far lower?

The obvious answer is that it is due to the low growth and inflation outlook for the European region where, following a further cut in lending rates and taking the deposit rate negative in early June, the potential for outright bond buying from the ECB persists. We believe this situation makes US Treasuries all the more attractive for European investors. Buying these higher-yielding bonds could allow investors to enjoy the higher coupon and, if the ECB’s intervention weakens the euro (as it has done for Japan and the yen), capture the currency appreciation to boot.

In our opinion it is these technical factors that are dominating the eurozone sovereign bond market and we continue to see little real value from these bonds at such depressed yields. 

As the global recovery picks up pace, we remain confident that investors who take a reasonable timeframe will be better placed in other risky assets.

The eurozone region remains mired in difficulty with high unemployment rates, low growth, meagre inflation and where dissenting voices have brought turmoil to the establishment in the recent European parliamentary elections. It is therefore no wonder that Draghi felt further action was required to stimulate the region.

Devalued euro

We believe one of the additional consequences and potential targets of his actions will be to devalue the euro, which should help to boost growth across the region. We have therefore hedged the majority of our euro exposure across the Jupiter Merlin Portfolios. 

In these uncertain times, it is by being aware of the changing environment and the opportunities it presents that we are  ready to act for  investors.

John Chatfeild-Roberts is chief investment officer of Jupiter Asset Management

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