Recently published economic figures show that the Euro zone has gotten off to a very good start to the year. The Composite PMI continued to rise, sharply outpacing expectations by reaching 56 in February, its highest level since April 2011. France’s economy stood out: the private sector fared better in France (with a PMI of 56.2) than in Germany (56.1) – political uncertainty notwithstanding – for the first time in nearly five years. In January, bank lending in the Euro zone continued to expand to both households (+2.2% year on year) and non-financial corporations (+2.3%). The European Commission’s Economic Sentiment Indicator was also up, reaching 108 in February after hitting 107.9 in January. Here again France stands out: confidence levels in the private sector rose in France from 105 in January to 106.1 in February, while the same indicator in Germany, although still very high at 108.3, has been slipping since December.
Bolstered by this improvement in economic activity and rise in optimism, the pace of job creation has returned to its pre-crisis level, according to the PMI's employment index. These brighter economic data are in line with our GDP growth forecast of 1.6% in 2017. They also prompted a rise in both the European Commission and consensus estimates.
However, the trend among core Euro-zone bond yields this past week appears to be out of step with these encouraging economic statistics. Despite the improved PMI figures, yields declined. Of particular note is the German 2-year bond – the Schatz – whose yield fell by nearly 14bp over the week to -0.95% on Friday. The sharp drop in German short-term yields widened their spread with French yields (the 2-year OAT yield declined by only 3bp to -0.52%, which pushed its spread with the German yield up from 32 to 43bp). Yet it may not be a sign of rising anxiety about political risk in France. The 10-year Bund and OAT yields both dropped by nearly 11bp this past week (to 0.19% and 0.93%, respectively), leaving their spread unchanged at 74bp.
The recent trend in German short-term bond yields appears to be driven by supply and demand. Demand for German bonds had already grown sharply as a result of the European Central Bank’s quantitative easing programme. Further demand is being driven by the new European Market Infrastructure Regulation on the bilateral exchange of variation margins for non-centrally cleared derivatives. This regulation, set to take effect on 1 March 2017, has caused investors to pursue very high quality bonds, notably German ones.
The performance of Euro-zone bond markets last week is a crucial reminder that, in view of existing monetary policy and new regulations, yield movements do not necessarily reflect a change in investors’ GDP growth expectations or risk appetite.