This outperformance could have been driven by two factors:
- The rising liquidity premium – the premium investors are willing to pay to hold the sovereign bond (in terms of lower yields) rather than a government-guaranteed agency bond of the same maturity
- Concerns over the European recovery and the risk of deflation
Figure 1 provides an estimate of the liquidity premium for bunds over the period. This is calculated by subtracting the yield on the bund from the agency bond. When there is demand for safe haven assets, the yield on the bund falls and the liquidity premium rises. Two such periods are highlighted in the chart, the first in February when investors became concerned about the impact of the crisis in Ukraine and the second in July when the Malaysian Airlines flight was shot down over Eastern Ukraine. However, despite these periods of heightened geopolitical tensions and risk aversion, the overall trend in 2014 has been a decline in the liquidity premium.
This suggests that concern over the European recovery and deflation played a more important role in the outperformance of bunds. Last week Mario Draghi, president of the European Central Bank (ECB), announced that the bank had “intensified preparatory work” on quantitative easing as a potential tool to fight deflation and the economic slowdown. However, markets were not convinced. The 10 year German breakeven rates (the difference between the yields of nominal and inflation-linked bonds) collapsed after Draghi’s speech (figure 2), while the spread between bund and periphery yields widened (figure 3).
Furthermore, Russian sanctions on Europe that impact growth have yet to be reflected in growth data. These are worrying signs that the ECB might still be behind the curve in terms of its policy action. We therefore remain neutral on German bund exposure even though yields are at multi- year lows.Leading indicators, however, paint a more positive picture. Typically the ratio of US non-residential fixed investment as a percentage of GDP vs. US durable goods orders (ex transportation) is a leading indicator for capex growth with a 6 – 18 months lead (see Figure 2).