Like over-ripe fruit of late summer, Italy’s positive real long-term yields are some the last remaining in the world’s major government bond markets, and they’re being plucked fast.
Italy’s sovereign borrowing premiums over German Bunds returned to pre-pandemic lows this week despite its soaring public debt. But while Italian bonds now possess the only positive 10-year real yields among Group of Seven economies - at just 0.3% this week - they are quickly heading towards zero.
Governments everywhere face mountainous new debt loads from the unresolved COVID-19 shock. Yet investors are betting major central banks will have to suppress long-term borrowing rates for governments and investment grade private firms for years to come to keep those debts affordable, and to keep credit flowing.
Unless central banks themselves disavow markets of that intention soon, all remaining real, or inflation-adjusted, yields will likely be snaffled away this year.
So with benchmark policy rates anchored near zero and long-term official bond buying in full flow, so-called safe bond yields have all but evaporated.
U.S. 10-year real yields plunged below zero in January - joining French, German and British equivalents that have spent much of the past decade in negative territory.
But U.S. Treasury real yields have continued to sink along with the others - plumbing depths below -1.0% this month - as investors bet central banks will sit on those rates long after there’s a recovery and a re-emergence of inflation.
SQUEEZING REMAINING JUICE
Super-charged bond buying programmes by the Federal Reserve, European Central Bank (ECB), Bank of Japan and Bank of England have much further to run and many expect they will be extended well beyond this year, even when the current plans expire.
Deutsche Bank last week said it expected the ECB to use up its entire 1.35 trillion euro ($1.6 trillion) COVID-related bond buying programme, or PEPP, by the middle of next year and adopt an explicit 2% “symmetric” inflation target after its strategic review of policy goals in 2021.
The latter would allow inflation to move above 2% for a period, looking at averaging an inflation target over time. Even so, Deutsche economists reckon persistent spare capacity in the euro zone means inflation will still likely undershoot 2% over the forecast horizon and see no rate rises in that time.
What’s more, it also expects the ECB to continue its pre-pandemic “Asset Purchase Programme” monthly net purchases, “with the risks tilted towards an increase being necessary”.
Chiming with that view, big investors such as BlackRock retain standing overweights on euro periphery government bonds, despite the steep fall in yields. “We see further rate compression due to stepped-up quantitative easing by the European Central Bank and other policy actions,” the giant U.S. asset manager said.
OUTLIER NO MORE?
Italy was the outlier for months due to its heavy debt-to-output ratio even before the pandemic, its severe hit from the virus early on and the peculiarities of the euro bloc that, once again, stoked fears this year’s shock could undermine the single currency and raise doubts about Italy’s membership over time.
But since those worries were lanced by last month’s EU agreement on the 750 billion euro post-pandemic Recovery Fund - involving joint debt sales and fiscal transfers to the worst hit - Italian 10-year nominal yields have fallen to below 1% and the premium over Germany has now halved from the March peaks of 282 basis points to revisit pre-COVID-19 levels.
Both the scale of ECB bond buying and reduced pressure on new debt sales from expected recovery fund transfers and next month EU’s unemployment support programme - on top of upcoming redemptions and reduced debt service costs - could have a huge impact on market dynamics going forward.
Morgan Stanley calculates that “a negative net supply technical will exist in Italy and Spain (as well as other periphery country bond markets) for the foreseeable future” - with potential negative net issuance, excluding Treasury bills, of some 53 billion euros for 2021 as a whole.
As a result, real 10-year Italian yields have gone from as high as 2.3% in March to just 35 basis points - even though that’s still juicy compared with -1% in the United States, Germany and France, zero in Japan and almost -3% in Britain.
Short of a resurgence of euro break-up fears, it’s hard to see how positive real yields will remain anywhere for long given the aggressive central bank assumptions everywhere.
Many leading financiers, including EU-advocate George Soros, claim Italy remains a worry if its politics shifts further to the anti-EU right.
But in an interview last week Soros also said: “I cannot imagine an EU without Italy.”
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