Bond yields of Portugal, Italy,Ireland and Spain have come off sharply from levels seen in January 2014 and are trading at record lows. Portuguese ten year bonds yields are down to levels of 1.61% as of April 2015 from levels of 3.58% seen in January 2014, a fall of 197 bps. Italian ten year bond yields are at levels of 1.19% down 198 bps from levels of 3.17%. Irish ten year bond yields are down 258 bps from levels of 3.30% to 0.72%. Spanish ten year bond yields are down 250 bps from 3% to 1.18%. Bond yields are trading at record lows for all these countries despite issues of high debt, lack of growth and lack of inflation in the Eurozone. Government debt as % of GDP is at 92% while inflation is at negative 0.2% and GDP growth at 0.3%.
Bond yields of these countries are below US ten year treasury yields of 1.90%.
The sharp fall in bond yields of indebted Eurozone nations is largely due to the ECB QE, where the central bank started buying Euro 60 billion of bonds a month in March 2015. ECB policy rate is at record low of 0.05% and discount rate is at -0.20%. Cheap liquidity is spurring trades to earn spreads on whatever asset is available in the market.
Bond yields have rallied despite the Greece bailout issue with the country securing an extension of four months for its bailout. The Greece bailout chapter is not yet closed and will rear its head once again. Greek ten year bond yields are at levels of 11.7% up 470 bps since last year indicating that markets are worried about Greece default.
The markets are searching for yields to park liquidity and that is driving the markets to bonds of Eurozone countries. The question to ask is what are the repercussions of these record low yields? Low yields may prompt governments to borrow and spend to come out of recession and if and when they do come out of recession, inflation expectations would rise leading to sharp rise in bond yields. Rising bond yields may make debt servicing expensive for these countries leading to a fresh fall into recession.
On the other hand, yields could stay down for long periods of time as Eurozone falls into a liquidity trap, like Japan. If this happens, liquidity would flood emerging economies such as India that offers growth and higher yields. Asset price bubbles would form in emerging economies, which is not a pleasant scenario for policy makers.
In the next two years, ECB QE will keep yields down in Eurozone countries and that would prompt large flows of liquidity into India. RBI would be buying USD to prevent sharp appreciation of the INR and will shore up foreign exchange reserves. Liquidity will be high in the system leading to bond yields falling and equity markets rising.
The hope is that ECB would come out of QE with causing much pain but it remains a hope. Until then the liquidity driven party will continue.
