Yield flood – QED

According to the chronicle of all things worth noting – Wikipedia – this was the date upon which Napoleon Bonaparte married his first wife in 1796, when the Barbie doll debuted in 1959, when the FTSE 100 hit its market low in 2009 and the S&P 500 began its seven-year bull market run. And now it is the date the European Central Bank started its bond-buying programme. That last entry has yet to be added to the Wikipedia page.

Prior to the announcement of the details of the quantitative easing scheme, there had been a growing chorus claiming that the ECB did not need to go through with its plan to buy €60bn (£43bn) in bonds each month as the economy was starting to build momentum. The latest gross domestic product figure showed that growth was indeed improving and that the private sector was finally starting to contribute more.

When combined with the improvement we are beginning to see in the credit cycle (for example, improved bank lending and demand for loans), it does start to paint a rosier picture for the year ahead. ECB president Mario Draghi certainly thought so at the press conference, claiming that the improvement was down to the impact of the policy measures introduced so far and that cheaper oil helped.

This may be true as inflation expectations have started to turn. Five-year inflation swaps, which look at longer-term inflation expectations being priced by the market, shows an increase. This is likely to be down to the improving eurozone growth outlook and a semblance of a stabilisation in the oil price.

According to the staff forecasts, the eurozone will expand by 1.5 per cent this year and slowly increase to a rate of growth of 2.1 per cent by 2017. Meanwhile, the rate of inflation will be kept flat for 2015 due to the lower oil and food prices, but will increase to 1.8 per cent by 2017. This could be interpreted as being pretty close to the ECB’s inflation target, which is described as “below but close to 2 per cent” over the medium term.

The doubt overshadowing the ECB’s plans is its ability to buy up that many bonds each month

Only Mr Draghi could raise growth and inflation forecasts at the same time as announcing the start of extraordinary monetary policy stimulus measures, as the two seem contradictory. The trick was to state that these new and improved forecasts could only be reached if the existing programme for QE was implemented in full.

The doubt overshadowing the ECB’s plans is its ability to buy up that many bonds each month. At €60bn a month, the ECB, through national central banks, there will be negative net issuance this year, meaning that the ECB is buying up more debt than countries are planning to issue. With such a big price-insensitive player in the market, those who already have sovereign bonds would have been wise to hold on to them longer until the price rose further, making it more difficult for the ECB to achieve its target.

However, the ECB’s floor on the yield at which it will buy bonds may get around this problem, freeing up more of the market for it to purchase. The ECB stated it would only buy sovereign debt with a maturity of more than two years and a yield of more than -0.20 per cent, or that of the current deposit rate. This signals to bondholders that price appreciation on the bonds will be limited and that by setting the floor on yields the same as the deposit rate, institutions should be indifferent to holding money with the ECB on deposit or selling their bonds.

The upshot is that yields in the eurozone are not going anywhere soon and are likely to fall in the near term as the market strives to figure out where the ECB is buying bonds. This also means that the 2 per cent + yield on offer on a US 10-year Treasury is looking relatively appealing and that as investors hunt for income, the yields in other bond markets are likely to be constrained. However, investors should be aware that yields will eventually move higher, especially as inflation expectations increase, along with volatility in the fixed-income market. Diversified and flexible strategies are the best way to protect portfolios and achieve a more efficient risk/reward trade-off.

Kerry Craig is global market strategist of JP Morgan Asset Management