Making Sense of the Bond Market Rally of 2014
Last Updated: June 23, 2014
- Lower overall economic growth and low inflation: Table 1 below shows data points from some of the key economies around the world. Notice the moderate GDP growth (Y/Y), relatively low inflation and the low 10-year government bond yields in some of the key developed economies around the world (Esp. USA, Germany, Japan and the EU). Despite the massive QE (bond buying) programs in Japan and the US, the year-over-year growth in those economies has been mediocre at best, inflation is still moderate and the bond market is reflecting this reality.
- Europe still remains a wild card and faces a slower growth environment: In early June 2014 and in response to the consistently low inflation and overall low growth environment, the European Central Bank (ECB) lowered the benchmark lending rate by 10 basis points to 0.15 percent, and lowered its deposit rate to minus 0.1 percent, becoming the first major central bank to make one of its main rates negative. And, in a bid to get credit flowing to parts of the economy that need it, the ECB also opened a 400-billion-euro ($542 billion) liquidity channel tied to bank lending. The recent geo-political tensions in Ukraine add to the fears of economic uncertainty and generate some safety demand for bonds.
- China continues to experience slowing growth: China’s government is trying to rein in excessive growth in shadow banking systems and strengthen control of local government borrowing, resulting in a slowing growth environment over the last few quarters.
- Improving US Budget Deficits: The US budget deficits have come down from over 12% deficit (as % of GDP) at the height of the recession in 2009-2010, to just above 4% deficit. Improving the fiscal situation while the Federal Reserve is still buying US government debt (treasuries and mortgage bonds) has obviously helped the bond market.
- Strong Appetite for long duration bonds from Pension Plans and Insurance Companies: With inflation relatively tame, and demographics favoring more bond allocations in some of their portfolios, demand for long-duration bonds from pension plans and insurance companies remains high as they try to match liabilities with assets.
- Short-covering by professional traders and hedge fund managers provide fuel to the rally: As of May 27, hedge funds and other large speculators cut net short positions in 10-year note futures by the most since February, according to the U.S. Commodity Futures Trading Commission. Primary dealers, who had net short positions in March for the first time since 2011, have since reversed those wagers, as shown by Bloomberg. Short covering usually leads to higher prices for the underlying asset and supports the higher prices in bond.