Curmi & Partners

The end of austerity!

Article by David Curmi

In my article titled Welcome to Purgatory in February 2017 I outlined the view that the party in government bonds appeared to have come to an end as prices in long dated government bonds showed early indications of having broken down, following 30 years of near relentless upward movements.  The price action in 2017 did not indicate a decisive breakdown in prices resulting in a year when government bonds prices in Malta were rangebound with a weaker bias, ending the year largely lower than their starting point. 

The early moves in 2018 suggest that the weaker trend in prices is likely to gain momentum.  Economic data in Europe improved throughout 2017 and prospects are arguably at their brightest in many years. At last austerity seems to have finally run its course in Europe with unemployment, though still high at 9%, at its lowest since 2008.  Consumers are indeed optimistic about the future. 

It appears that Mario Draghi has almost single handedly dragged Europe from the brink of collapse and slowly steered it back to a growth path with Europe’s economies expected to grow by some 2.4% in 2018.  With this shift back to growth gaining momentum, Draghi has already indicated that the volume and extent of purchases under the QE program will be reduced from September 2018. Next in the cross hairs will undoubtedly be interest rates.  Here, lower for longer remains the current status quo with the first move upward not expected until 2019. 

Bond markets however are forward looking mechanisms and will already be looking to price in the first interest rate rise.  In fact 10 year government bond yields in Germany have already moved decisively higher this year, to 0.7% from 0.43% at the start of the year. Here in Malta we have not seen a similar move in local government bonds, although two year government paper is now giving a positive yield after languishing in negative territory since early July. The reason for this is perhaps more to do with the way the local market functions.  Price adjustments do not necessarily happen immediately.  In fact, following the fall in German government bond prices, the spread between German 10 year paper and the Maltese equivalent is now just 0.71%, from 0.84% as at end 2017.  Something is not right here.  In the absence of news about an improvement in Malta’s credit quality I can only but assume that price adjustments will take price, but with a lag.

This presents an interesting challenge for both new issuers of bonds and for investors in such issues.  It is likely to be the first time that local bond issues will come to the market against a sustained backdrop of rising yields.  Over the years, the various new bond issues have been met with an equally ravenous appetite of yield hungry investors. The calendar for new bonds is filling up for this year.  It will be interesting to see how tightly such bond issues are priced, especially against a backdrop of a number of new government bond issues set for this year. The baton has clearly been in the hands of the issuers so far.  Are we about to see this change?  Not for now but my take is that the grip is weakening.

Earlier in the week the Treasury announced that the government will be raising an amount not exceeding €350m in new bonds.  This issuance however is not to raise new money as the government will be refinancing €391m of maturing bonds.  After being absent for much of 2017, the type of tenure and pricing of new government bonds, and the uptake of these bonds, will begin to have an impact on any new corporate bonds also coming to the market.  Because of this and for the first time in many years, investors are likely to see the beginning of upward pressure develop on corporate bond yields.  This will be good news for the long suffering savers, who have, over the years,  seen their incomes slowly whittle away as a result of lower interest rates imposed by the ECB.  Before too much excitement develops, it is unlikely that we will see any large moves.  Keep in mind that inflation remains stubbornly low in the western world and this stickiness is allowing central banks to adopt a very gradual approach to such moves.  It is light at the end of the tunnel, but the tunnel is long.


The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business