- In the wake of Covid-19, developed markets’ long-term yields have fallen significantly. However, market participants seem uncertain how to integrate the ensuing massive fiscal and monetary easing in their medium-term rates expectations.
- Our proprietary long-term sovereign yields model points to a persistently low interest rate environment over the next few years; the massive, prolonged intervention of central banks on global government bonds will remain a major factor.
- However, the additional flows of risk-averse private financial savings will also exert a remarkable downside pressure on long-term yields. In the Eurozone, the cumulative flow of private financial savings has so far exceeded the volume of QE. We expect the rapidly growing amount of fresh financial savings not to be matched by a proportional increase in the free float of safe assets.
- As to metrics of public debt, our research suggests that they do not have explanatory power on yield levels in developed markets in the medium term.
- We believe there are only two possible scenarios in which long-term yields could possibly see a significant rise: an inflationary shock or a monetary policy error. But even in these cases the increase would be limited. For the 10y German Bund the yield would rise to around 0%; for 10y U.S. Treasuries the yield would increase to 1.8 to 2.0%.
- As for Euro sovereign spreads, they have also become much more sensitive to the interventions of the central banks and private sector savings than to any debt-related factor.
Mid-term rates outlook
In the current environment, forming expectations about long-term interest rates on a medium-term horizon is a challenging task. Market participants do not yet seem unanimous on how to represent the massive fiscal and monetary easing in their valuation models.
We have identified a series of factors that have proven highly significant for the mid-term development of U.S. and Eurozone yields over the last 60 years. These factors are (see Table 1):
· Nominal trend GDP (long term inflation expectation + potential real growth)
· Central bank Quantitative Easing (volumes, length and reinvestment policy) and its effect on government bond supply and duration risk
· Long-term expectations of neutral rate (using an adaptive expectations algorithm on policy rates)
· Short-term expectations of policy rates as priced by money market forwards
· Private sector risk aversion and financial savings propensity (safe asset demand)
Given the relevance of each factor and its sensitivity, it is possible to derive a mid-term outlook for 10y yields in the U.S. and the Eurozone.
Table 1: 10y Bund yield fundamental factors