Yield backup alert: This is NOT the real thing — this is a drill
But it's a live-fire drill, and it's supposed to keep you on your toes
Bond yields backed up sharply today in Europe and the US Treasury market followed. The prime mover in European markets was not bonds — it was Italian bank stocks, which soared after the European Union’s chief bank regulator proposed a lenient policy towards banks’ bad loans.
Why should bank stocks send the bond market tumbling? Because the European Central Bank’s massive quantitative easing, which now amounts to 40% of Eurozone GDP, responded to Europe’s 2012-2014 banking crisis. Germany and the Netherlands reluctantly went along with European Central Bank chief Mario Draghi’s “whatever it takes” quantitative easing” because a financial collapse in Europe would hurt everybody.
But German patience only goes so far. Once the Italian banks are out of danger, the Germans have told their European partners, quantitative easing has to come to an end. That’s why European bonds tumbled after Italian bank shares rose. US Treasuries followed German bonds down.
As noted, this is a drill: the real event will follow the formation of a German government at the end of this year, which will bring the Euroskeptic Free Democratic Party into the Finance Ministry. In the meantime, though, the German Establishment has delivered stern warnings that quantitative easing has to end. The latest salvo came yesterday from the German Council of Economic Experts, the consensus recommendation from the country’s five major economic institutes, which called for an end to QE.
The Germans, to be sure, don’t want to shock the market. Their biggest complaint is negative interest rates, which hurt German savers to the benefit of Italian, French and Spanish debtors. The next step is likely to be a fixed terminus for the ECB’s purchases of European government bonds, which will fall from Euro 50 billion a month during 2017 to Euro 30 billion a month in Janury 2018.
An increase in short-term interest rates may not happen until 2019. As we saw today, the bond market will be subject to a number of drills before the actual event. Rising European term yields will put a headwind in front of stocks–except for bank stocks, which benefit from higher yields. With European bank stocks cheap to the rest of the market, they appear to be the most attractive sector of the European stock market.