“I would only say that we are in a process of normalisation…That is why we have increased rates twice and why there will be an increase in rates in the future.”

 — Jean-Claude Trichet, ECB Press Conference, 6 April 2006

Bond market participants have had the sense for several years now that the level and shape of yield curves around the world have not been “normal”. Alan Greenspan, the former Fed chairman, used the word “conundrum” to express his bewilderment with regard to the low level of long yields in the US and many others noted the extraordinary low level of front-end yields globally. The recent increase in bond yields might indicate that the global process of normalisation that started in June 2004 with the first rate hike of the Fed is well under way. “Normalisation”, a word Trichet used in the April ECB press conference, mirrors well what central bankers are targeting and this “normalisation” might not only concern the front end of the global curves but the shapes of the curves, the level of risks premia and possibly the implied volatility levels.

Euroland, like Japan, Sweden or Switzerland and unlike the US and UK, is just starting its normalisation process and we will primarily focus our analysis on this market. In Euroland, two questions are crucial: 1) Should we expect yield levels and curve shapes to normalise towards historical averages? and 2) Does the Euroland curve protect the bond investor enough from a continuation of the normalisation process and what is the right curve positioning? Let’s address both of these questions.

Today we can sort the global bond markets into two groups: those nearing the end of the normalisation process at the front end of the curve, such as the US and the UK, and those just starting the normalisation process with Euroland and Japan being the obvious examples. The former bond markets exhibit very flat yield curves (Chart 1); the latter exhibit steep yield curves (Chart 2). In principle, as a bond manager one will tend to favour (overweight) the former markets with a flatter curve and position for the next curve move, i.e., a steepening. In Euroland and Japan though, one would tend to be more defensive with the interest rate risk (duration) and position for a flattening of the yield curve (barbell strategy).

Since the end of last summer, the Euroland bond market has experienced a strong increase in yields across maturities but especially at the front end (Chart 3). This mirrored the economic recovery taking place in the Euro area as well as the change in the ECB’s monetary policy stance. The ECB hiked the first time in December 2005 and then a second time on 2 March 2006. There is no doubt the ECB considers the job of normalisation as far from done. In fact, while the ECB has always stressed the uncertainties associated with the measurement of a neutral rate, the central bank did indicate in its May 2004 Monthly Bulletin that “most estimates point to a range between 2% and 3% for the natural real interest rate of the Euro area at present”. That suggests a neutral ECB rate close to 4% and potentially a bit higher. At the current ECB rate of 2.5%, the sum of potential rate hikes required to reach the neutral rate is at least another 100 basis points.

Has the ECB good reasons to “normalise” the level of rates and target a return to the neutral rate? Well, we know that the primary inputs the ECB analyses in deciding its policy are three-fold: economic developments, money supply and inflation. GDP growth in Euroland is on its way to exceed 2% in 2006. Furthermore, credit growth to the private sector is exceeding 10% year-over-year and the inflation rate is north of the ECB target of 2% (last CPI print for the Euro area was 2.2% year-over-year in March). As a result, these three components of the ECB analysis continue to suggest that liquidity is ample in the Euro area and that the path is clear for the ECB to “normalise” further. The consumer will be key though and the high level of unemployment and low level of real wage gains should limit the economic recovery. In the short run, the European consumer is the first victim of secular European economic restructuring and social reforms. This secular disinflationary force, which I described in January 2005 in this publication, is likely to inhibit the ECB from hiking as swiftly or to the same magnitude as previous hiking cycles (Chart 4).

Having said that, faced with a central bank that wants to normalise the level of its base rate and with an economy which is recovering, the obvious strategy for bond investors is to take a defensive stance in duration and curve positioning. In other words a lower than normal interest rate risk and a barbell positioning on the yield curve are in principle warranted in Euroland. The bond market is vulnerable and the best protection against a further underperformance of the intermediate maturities is to overweight the very front end and the ultra-long end of the yield curve. Current valuations at the front end of the Euroland yield curve offer some protection but positioning must be very precise. The Euribor December 2006 contract discounts a three-month rate of 3.53% at the end of the year (i.e., an ECB rate between 3.25% and 3.50% including adjustment for risk premium). Given the current point in the tightening cycle, this level offers some protection and even a potential capital gain should the ECB pause before reaching the 3.50% level. Remember that since the ECB announced the new hiking cycle in November last year, it has hiked 50 basis points in six months. The pace of the new hiking cycle has been slow until now and the risk is that it could accelerate somewhat. However, given the recent pace of rate hikes, and assuming a hike by the ECB to 2.75% in June, a discounted market level close to 3.50% by year-end looks fair, if not attractive.

Looking further out on the curve though, we notice much less risk premium. For example, the three-month rate starting in December 2007 quotes 3.86%, which suggests that the market discounts a fairly muted ECB next year, with only one additional hike of 25 basis points. For the sake of comparison, the last time the ECB was hiking its rates and crossed the 3% level in December 1999, the two-year swap yield quoted 4.50%. On 26 April 2006, the market discounted a two-year swap yield of just 3.75% when the ECB hiked to 3% (discounted for August this year). This is not enough protection at this point of the tightening cycle and the intermediate maturities of the Euroland yield curve do not offer value. Again, the monetary analysis, the economic analysis and the inflation analysis do not suggest a pause soon. The ECB’s normalisation process is far from over.

At the other end of the maturity spectrum, the long end of the curve continues to appear attractive. We noted in this publication last year that the increase in structural demand should support the outperformance of the 30-year and longer maturities. New accounting standards and regulations that favour fair value have been leading life insurers and pension fund managers to invest more in the long end of the curve than before. In a rising rate environment, more attractive absolute levels of yields should help accelerate the reduction of the duration gaps between assets and liabilities as more long duration assets are added in the portfolio. Like we saw at the end of last year in the UK, a strong equity performance that improves funding ratios can also lead pension funds managers to hedge their duration risks faster than previously expected, given their more favourable position. The issuers of long duration assets, primarily the Euroland governments, have not shown a lot of willingness to increase significantly their offer on the long end of the curve. In fact, after meeting with the largest European debt agencies, we remain convinced that we should not expect the supply of long bonds to meet the demand. Their low average duration targets would even suggest some moderation in issuances at the long end going forward.

On top of the structural demand for long duration bonds, the hiking cycle of the ECB is the second ingredient for a further flattening of the yield curve. As was the case in the last months, the long end of the curve is likely to outperform going forward this year (Chart 3).

Normalisation of rates means defensive duration and curve stances, particularly in Euroland where this process is just beginning. What may sound like a bearish view for the Euroland market should be clarified by the following remarks:

1. The sell-off of the last months, as discussed above, has made valuations more attractive and the very front end offers both protection and potential capital gains.
2. The secular disinflationary forces of economic restructuring and social reforms still offer strong support for the Euroland bond market as core inflation should remain low and internal demand subdued.
3. Higher yields today compared to 12 months ago are in principle good news for long-term investors, provided inflation continues to remain under control.

Matthieu Louanges, CFA