- The latest wave of QE has absorbed the entire available supply of the German Bund market.
- Over the summer, QE purchases have pushed the free float to zero.
- The ECB is still trying to purchase c.€20bn per month.
- This has sharply decoupled bund yields from economics, potentially misleading investors – providing an opportunity and a risk.
The decline in bond yields over the last three months has had many investors scratching their heads. What was particularly odd was that the yield decline took place in the face of a steady climb in long-dated inflation expectations. The fundamental valuation support for bonds weakened, yet yields fell.
Short covering, an interim peak in economic momentum and the delta variant have all been proposed as an explanation, but none are sufficient. The real driver is likely that the free float of German sovereign bonds has now all but disappeared – and the ECB is still trying to buy approximately €20bn per month.
The ECB has two purchase programmes – the Asset Purchase Programme (APP) and the much larger Pandemic Emergency Purchase Programme (PEPP). Over the course of the summer of 2021, these programmes have taken out the remaining small float of German bunds. As there are very few bunds left to buy, even small amounts of QE can have an outsized impact on price, forcing yields to decline.
There are three types of government bond holders that we need to consider when calculating the free float. The first is of course the ECB. The second are foreign central banks. These securities are held as part of strategic foreign exchange reserves and so these holdings are not for sale. These holdings are large, and in absolute terms are larger than ECB total holdings. Both ECB and foreign central bank holdings are removed from the free float in this exercise.
The third category of owner to include are bonds held by commercial banks for regulatory purposes. Since the Financial Crisis, commercial banks have been forced to hold a large proportion of government bonds under the Basel III rules. These securities are classified as high quality liquid assets (HQLA) and they are owned as part of bank regulations that force banks to maintain high liquidity on their balance sheets. These securities are also removed from the free float.
Of course the ECB can prize some bonds away from banks and foreign central banks, but these are price inelastic holders who are not supposed to be selling. The result is the ECB is having an even more outsized impact on price today than usual. Since German bunds are the reference rate for the Eurosystem, their drop in yields has helped to pull down yields across the developed world. Low German yields contribute towards anchoring US Treasuries and UK Gilts.
The German Bund market is a special case where the free float is smallest. There are two reasons for this. First Germany’s debt to GDP is relatively low at 71%, so there are less securities available to buy than in other countries. Second, foreign central banks own proportionally more German debt in their foreign exchange reserves than they own of other EU country debt. They are over-indexed in bunds compared to Italian BTPs.
Below we show a chart of how the German Bund free float has changed over time, from 2004 to today. We also overlap this chart with bund yields themselves on a separate axis. The IMF’s Monetary and Capital Markets Department provides a database of the holders of sovereign bonds for advanced economies. For the chart below we include a mixture of IMF data and ECB data.
The ECB has also discussed the free float and its impact on yields. Benoît Cœuré, former Executive Board member of the ECB made a presentation on this subject in February 2018. The ECB use similar methodology and data sources to the above but do not include commercial bank holders. Under their methodology they estimated the bund market free float was as low as 15% in late 2017.
There are a number of implications for markets from this development:
First, German Bund yields cannot be trusted to provide an accurate message about the economy. This may have been the case for some time, but the distortion has become even more extreme in recent months. Bond yields are far lower than they should be based on economic fundamentals. This may be misleading investors about the trajectory of the economy. In recent decades investors have been conditioned to believe the bond market is always right, with bonds predicting the ebbs and flows of economic momentum. But the scale of distortion in sovereign bonds is so great that equities cannot rely on the bond market message anymore.
An untrustworthy bond market is especially relevant today since the recent yield decline has helped to cause a de-rating of cyclicals and re-rating of secure growth stocks. The yield decline is not the only driver of this de-rating of cyclicals, but it has made an important contribution. If equities have read the economic picture too negatively because of a distorted move in bond yields, this is an opportunity. Many well managed cyclical equities are especially cheap today relative to expensive growth stocks. Financial conditions have also become easier. This sets the scene for a potential period of alpha generation for cyclical value equities over expensive growth equities in the coming months.
Second, the ECB may have to adjust or taper QE soon for practical reasons. It is probably not a coincidence that the European Commission starts to issue bonds on September 15th and Green Bonds in October. The ECB will likely have to pivot away from buying sovereign debt and start buying EU Commission debt if they are to maintain their pace of purchases.
Third, it is the Sovereign debt market free-float that now dictates yields more than the macroeconomy. Anything that increases the free float, whether through more debt issuance, or tapering, ought to lift yields. It is quite possible to see yields rise, even with the economy slowing, if the free-float of those debt securities is rising.
This brings us back to what we at Lightman perceive to be the pre-eminent risk to markets and to world wealth. The risk is not so much to earnings, but rather to the multiple the market is willing to pay for those earnings. Global markets have been hugely lifted by ultra-low discount rates. But this manipulation of the discount rate has reached a point of exhaustion. There are no more bunds left to buy. The discount rate cannot be lowered. Stimulus will now take different forms. These new forms of stimulus may steepen yield curves, not flatten them. Investors should position accordingly. If the discount rate has bottomed it is a time to be cautious of expensive assets of all kinds.
The LF Lightman European Fund is value focussed. We are optimistic about the outlook of the earnings of our companies, with secular drivers supporting the entire portfolio, but we are disciplined on price. We pay low multiples for our holdings’ cashflow and earnings. In a world where discount rates have bottomed, low valuation ought to be a critical component of risk management.
IMF, ECB, Huw Worthington at Bloomberg Intelligence, Lightman – September 2021.
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