Interest rates creep up – and investors don't like it

As fears of a breakup of the eurozone receded and good news on economic data became more frequent, investors moved out of 'safe' bonds

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In their hunt for yield, investors have been moving into riskier markets and assets from bonds such as US Treasuries that are traditionally considered safe.

This has happened gradually since a speech by European Central Bank President Mario Draghi last year - in which he promised that the central bank’s measures to defend the eurozone from fragmentation will be enough – restored markets’ faith in the single currency area’s ability to sort out its problems.

Returns on the S&P 500 index exceeded 6% since the end of November, while in the same period the return on US Treasuries has been minus 1.3%, according to Reuters.

Last week, yields on 10 US Treasuries rose above 2% for the first time since April 2012, as investors sold off the safe haven bonds in search for higher returns.

Some analysts are not too worried about this move at the moment.

“This trend must be seen as a normalization process rather than a bond crash,” because economic conditions and inflation expectations “remain subdued” and central banks are expected to keep their monetary policies accommodative throughout the year, Patrick Legland, a strategist with Societe Generale, said.

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However, Legland warns that the “risk-on” mood cannot last for long, as the increase in interest rates in the developed world could crush the fragile recovery.

China’s “cyclical rebound” – as reflected in the robust increase in industrial profits in November and December – supports the risk-on trading mode for now, as the threat of an immediate hard landing has faded, he said.

But analysts believe China’s recovery could fizzle out in the second half of the year and that its economy needs to turn into a consumer-driven one from the current investment-driven model if it is to continue thriving.

NEW WORRIES ABOUT EUROPE

And it isn’t just the increase in US Treasuries yields or China’s patchy recovery that preoccupy analysts. It’s Europe too, this time as a source of monetary tightening.

David Simmonds, head of currency and emerging markets strategy at RBS, noted that although volatility was still low, things were changing.

“The aroma of volatility is perceptibly stronger, partly because of the high stress seen in front-end European rates markets this year,” Simmonds wrote in a market note.

“This stress has important, perhaps durable, consequence. The capitulation of lower for longer European rates positions probably resonates louder for longer precisely because no one expected it.”

He gave the example of what happened in Denmark at the end of January to illustrate the effects of any monetary policy tightening on markets. The Danish central bank raised interest rates by a tiny 10 basis points, bringing its benchmark lending rate to 0.30% and the rate on certificates of deposit to -0.10%.

“Hardly earth moving? But the impact on yields further out was instant,” Simmonds said. “Two-year Denmark went from ‘nought to 60’ in seconds.”

“If this is what happens to two-year rates on a 10 basis points Denmark policy move, does anyone really think the Fed can engineer an orderly exit from quantitative easing one day? Not a chance, in our opinion,” Simmonds added.

He warned that rising bond yields pose a serious problem for the ECB, as eurozone liquidity is tightening and the money that banks borrowed under its Long-Term Refinancing Operations (LTRO) is being paid ahead of deadline because appetite for periphery bonds and funding conditions for banks have improved greatly.

But on the other hand, any indicators pointing towards “green shoots” for the economy relate to the earlier significant loosening of monetary conditions, he said.

The flow of capital from safe havens into risky assets has benefitted emerging markets, especially stock markets, but also the S&P 500, which has rallied this year, with some analysts predicting it will hit 1600.

“With the lack of positive economic data, the S&P500 looks overvalued and therefore the risk-on mode could come to an end in the near term,” Legland said.