After last week's unsurprising announcement that the ECB will start asset-backed securities, bond yields that fell in anticipation have been rising over the past few days. 10-year US treasury yields having hit 2.3%, are now trading at 2.49% and look like breaching the 2.5% barrier. Spanish 10-year bond yields have risen modestly so far, and the German 10-year bund is close to breaking back above 1%. UK gilt yields currently trade at 2.48%; so far the Scottish referendum has not impacted the gilt market.
We did refer in passing the other day that perhaps the ECB moves last week will be seen as the low point in bond yields, and on reflection we are coming more of this view. Why are we coming to this viewpoint? We believe we may be at the high point in the liquidity cycle that has existed over the past five years, as there are some signs, for example recent hourly wage data in the US indicate that some inflationary pressures are building up.
In our view, the ECB, against current popular opinion, will not introduce the US equivalent of QE by buying government bonds. We believe this for two reasons, firstly on more than one occasion Mario Draghi has pointed out that QE in Europe is more complicated than in the US; “which country’s bonds do you buy?” and “how much of them do you buy?” are just two of the unanswered questions. The second, and possibly just as important, reason is that the German government would oppose the move, probably suggesting it is against European law. Germany has expressed concerns over last week's announcements, they are unlikely to sanction full blown QE as we have come to understand it. So as far as Europe goes, this is it.
For the US and UK we know the next move is to raise rates, the tightening process is going to commence at some stage probably in the next 6 months, if only slowly. Japan has so far resisted the introduction of addition quantitative easing and the recent rise in the US dollar has weakened the yen, doing some of the work for Prime minister Abe. In China one may see another cut in the reserve rate ratio, but that is likely to be the extent of it. So there it is, central banks that have been providing liquidity in a coordinated way may start now to very slowly withdrawing it, if only very gently. On that basis, longer dated yields should start to rise.
What equity investors need to watch for is a gentle rise in yields not a sharp jump. They also have to bear in mind that equity markets tend to fall not at the start of the rate tightening cycle but at the end, and we are a long way from that.