F&C Investments’ Michiel de Bruin, head of Global Rates, comments on the continuation of loose European monetary policy and how it may support longer-dated eurozone bonds:
Europe lags UK and US economic recovery
Currently, long-dated government bonds issued in euros have an advantage in that monetary policy in the eurozone is less advanced in its cycle than the UK or US.
With the US and UK economies growing at a much brisker pace than the eurozone, America’s Federal Reserve and the Bank of England are preparing the way for tighter policy to keep inflation at bay and prevent an economy from overheating. In contrast, the European Central Bank (ECB) is still doing all it can to revive an ailing economy.
The periphery nations may be doing better but growth in France has stalled and Italy has slid back into recession. Even Germany suffered a contraction in the second quarter. To compound the economic problems, the intensification of the Ukraine crisis weighs on confidence and sanctions against Russia are likely to hurt the EU almost as much as their intended target.
Threat of deflation prompts talk of looser policy
To add to the ECB’s headache, inflation is on a sharply declining trend and now sits at just 0.3%. If this turns into outright deflation (i.e. prices falling), the eurozone economy could be tipped back into a deep recession. On its own, this deflationary threat is enough to underpin long-dated bonds, even if they appear considerably overvalued on most measures.
Being confronted by such challenges, the ECB is the only major central bank that has been actively talking about loosening monetary policy further. June saw interest rates lowered to 0.15% and then trimmed once more to just 0.05% in September. Some market observers had expected the Bank’s president, Mario Draghi, to introduce some unconventional monetary policy measures such as quantitative easing (QE).
However, his stimulus plans fell short of full QE (government bond purchasing) and he instead pledged a watered-down plan involving the purchase of asset-backed securities.
QE could push prices higher
QE is seen by some as a last resort, but if the ECB does eventually start its own version, long-dated bond prices could rise further. Indeed, over recent months market participants have convinced themselves that the ECB would embark on further unconventional measures.
This has resulted a sharp bond rally as investors remembered how well US and UK government bond markets had responded in the run up to QE announcements in those countries. However, after the implementation, it is noticeable how these rallies lost most of their momentum.
The expectation of more stimulus by the ECB should continue to underpin eurozone bonds as the winding down of QE in the US is ongoing and expected to be completed in October. This is likely to be the trigger for a rise in yields in the run-up to a hike in interest rates, possibly in the first quarter of 2015. By contrast, the timeline for rate rises is much more extended in the eurozone, with no change envisaged before 2016.
Longer-dated bonds a haven from volatility
Overall, the outlook for longer-dated bonds issued in euros is brighter than those denominated in the other major currencies, particularly in the context of rock-bottom interest rates and looming deflation that are hanging over the eurozone. Long-dated bonds should also continue to enjoy structural demand from pension funds as trustees strive to meet their schemes’ liabilities.
With the economy looking increasingly fragile, long bonds can offer a safer investment haven from volatility in riskier assets. The current uncertainties in Eastern Europe will only add to their attraction. In absolute terms, however, returns over the next twelve months are unlikely to be as impressive as the last twelve months.