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The bond market’s compass is out of order

Arnaud-Guilhem LAMY

With eurozone interest rates well adrift from the basic calculation of ‘growth plus inflation’, anchorless fixed-income investors need something solid to grab onto. Investment-boosting fiscal policy initiatives in 2020 could be the lifeline they’re looking for, Arnaud-Guilhem Lamy, co-head of aggregate specialty fixed income, tells The Intelligence Report.   Short-term interest rates have been negative for five years in the eurozone The simple rules no longer prove true A bumpy road ahead in coming months    

More than five years ago, on 5 June 2014, the ECB lowered its key interest rates, taking the deposit facility rate to -0.10%. This September, this rate was cut further to -0.50%. Eonia, the overnight reference rate for the euro, has just marked five years of negative rates too and, to put it mildly, many in the markets are struggling to make sense of it all.

Bond yield’s ‘golden rule’ has lost its shine

The 10-year German Bund yield no longer follows the simplistic calculation of ‘growth plus inflation’ that has held for decades. From 1999 to 2007, the yield was on average 40bp below this ‘rule’. It could vary significantly, but the long-term relationship between the level of long-term interest rates and nominal GDP growth remained valid.

Ever since Eonia has been negative, this relationship has ceased to work, with rates consistently and significantly below the level given by the formula sometimes known as the ‘golden rule’ – by 270bp on average since the end of 2014.

Exhibit 1: The relationship that broke down in 2014; eurozone: nominal GDP and 10-year Bund yield (in %)

Exhibit 1: The relationship that broke down in 2014; eurozone: nominal GDP and 10-year Bund yield (in %)


Expectations of a cut in policy rates or asset purchases – known as quantitative easing – by the ECB may have been behind long yields falling to negative levels. The 10-year Bund dropped as low as -0.71% in the summer of 2019. The notion of the ECB running out of ammunition to prop up the eurozone economy and fan inflation has, by now, become largely consensual, but the possibility of an increase in key interest rates looks far off at this point.

The best reference points: current or future growth and inflation?

Some observers will argue that it is unwise to look at current growth and inflation, and that rates need to reflect future growth and inflation, and they will be right. However, even though the IMF and the European Commission recently revised down their eurozone growth and inflation forecasts for 2020 and 2021, these remain above 1.2% and are therefore far from pointing to recession!

Without a fundamental fixed income anchor, investors are focusing solely on short-term movements. This explains the exaggerated reaction to various (presidential) tweets and geopolitical news, depending on whether these increase or reduce the likelihood of near-term recession in the eyes of investors. (BNP Paribas Asset Management is forecasting no recession in 2020.)

Exhibit 2: Trends in long-term interest rates in 2019 (yields in %)

Exhibit 2: Trends in long-term interest rates in 2019 (yields in %)

Data as at 6/12/2019; source: Bloomberg, BNPP AM

Such erratic movements look likely to remain the norm for the foreseeable future, with the 10-year Bund fluctuating between -0.70% and 0% as long as the ECB maintains its monetary policy and the economy does not improve significantly.

Fiscal policy support could make monetary policy more efficient

In her first official speech[1] as president of the ECB (The future of the euro area economy, 22 November 2019), Christine Lagarde spoke little about monetary policy, choosing to repeat that the eurozone central bank “could achieve its goal faster and with fewer side-effects if other policies were supporting growth alongside it.”

Fiscal policy will undoubtedly be a theme for investors to watch in 2020. Official calls, especially when issued by central bankers, are aimed at boosting long-term investment rather than consumption, and at responding to weak potential growth.

Of course, if such policies were to be put in place, their effects would not be seen immediately. However, markets could react quickly in the short term to decisions that have a long-term (reflationary) impact.


This article appeared in The Intelligence Report – 10 December 2019

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