Look Out for Sovereign-Bond Volatility
Sovereign bonds have been full of surprises this year: From the U.S. to Spain, yields are declining further after confounding investors' expectations by staying low for most of 2014. It's a trend that could be setting markets up for greater volatility in 2015.
The level of interest rates is truly remarkable. Who would have predicted that toward the end of the year, U.S. 10-year Treasury bonds would yield only 2.12 percent, German bunds only 0.62 percent or Japanese 10-year bonds only 0.37 percent? Even more financially challenged governments, such as Italy, Portugal and Spain, have seen yields fall to record lows.
The trend has three main drivers. First, with the exception of the U.S., almost all the systemically important economies have seen their growth projections deteriorate. The International Monetary Fund's forecast for global growth in 2015 now stands at 3.2 percent, down from 3.9 percent a year ago.
Second, inflation projections have come down, and will probably fall further given the sharp drop in oil prices. Declining oil prices will reduce the cost of products for which energy is a major input, and -- on the margin -- will encourage central banks worried about deflation (such as the European Central Bank) to keep monetary conditions looser than they otherwise would.
Third, many investors have stayed away from U.S., German and Japanese government bonds or even bet against them, on the expectation that yields would rise and prices would fall. As the market has gone in the other direction, they have been forced to buy bonds to get out of their positions. The October "flash crash," in which U.S. Treasury yields fell to less than 2 percent, flushed out quite a few of these investors -- but far from all of them.
The trend toward lower yields has been oddly pervasive, ignoring important differences in individual countries' economic outlooks and government finances. There are just three significant exceptions:
- The yield difference between U.S. Treasuries and German bunds has increased to nearly 1.50 percentage point, from about 1.05 at the beginning of the year -- recognizing the diverging outlooks for growth, inflation and central bank policy in the U.S. and Europe.
- The yields on Greek and Russian debt have risen sharply compared to German bunds and U.S. Treasuries, reflecting perceptions of increased credit and default risk.
- In some emerging economies such as Brazil, increasing yields reflect growing concerns about excessive dependence on tighter monetary policy to compensate for inadequate fiscal policy.
One big question for 2015: Will such exceptions remain small and isolated, or will yields diverge more broadly along with different countries’ growth, inflation and policy prospects?
If yields fail to reflect growing divergences in economic and financial fundamentals, they will place more pressure on currency markets to serve as global shock absorbers. The more this happens, the greater the risk that large currency moves will end up breaking something else in the system. On the other hand, sharp moves in yields that better reflect credit and default risks can also cause problems -- for example, by making it harder for governments with shaky finances to borrow the money they need to pay off maturing debt.
In any case, the bigger the disparity in economic paths, the greater the risk of instability in 2015.
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