Pressure is rising on the European Central Bank to do more to support the economy and boost lending as inflation in the 18-country bloc remains well below the central bank’s target of just below 2%. Mickael Benhaim, co-head of Global & Regional bonds at Pictet Asset Management, discusses the outlook for European bonds as the guessing game intensifies over the timing and scale of the ECB’s sovereign bond buying programme.
From the perspective of a seasoned central bank watcher, the current market situation and policy divisions inside the ECB are reminiscent of what investors experienced before the US Federal Reserve launched its second round of quantitative easing (QE2), in the second half of 2010.
There are clear parallels – before eventually deciding on a $600 billion bond buying plan, then-Fed chairman Ben Bernanke faced fierce political resistance, with the anti-QE camp warning the programme would stoke inflation and lead to a collapse in the USD. Today, ECB President Mario Draghi is trying to convince the QE critics – mainly Germans – who claim sovereign bond buying would amount to illegal financing of governments, lead to 1920s-style hyperinflation and fuel asset price bubbles.
But we do not expect the similarities to end there. The euro zone yield curve is set to behave in a way similar to that of its US counterpart four years ago.
In the run up to the launch of QE2 in November 2010, or what we call the anticipation phase, the gap between 10- and 30-year US Treasury yields was stable at around 100 basis points.
Ready, set, steepen
However, the curve shifted once the Fed dropped a hint over QE. The 10/30-year yield curve steepened to 160 basis points over the period of a few months1 because the long end of the curve sold off more than the short end in a move known as bear steepening. This is because the Fed’s QE raised expectations that inflation would rise in the long-term.
We can foresee a similar trading pattern in euro zone government bond markets. German yield curves are currently on a flattening trend – yields on longer-dated bonds are falling because investors expect euro zone inflation to move further away from the central bank’s target. The 10- and 30-year curve, as a result, stands at around 80 bps.
Over the next few weeks, we think investors can benefit from positioning themselves for a steeper curve as Draghi prepares to expand the central bank’s balance sheet towards its level of early 2012-, €1trn higher than it is today- and boost long-term inflation expectations.
When the ECB drops its first clear hint on the timing of its sovereign bond purchase plan, we expect the euro zone 10/30-year curve to steepen – and by a far greater magnitude than its US counterpart did under similar circumstances in 2010. That’s because, unlike the Fed, we think the ECB may want to limit the maturity of sovereign bonds it would buy to up to 10 years.
EUR to weaken further
Another way to position for QE in the euro zone is by building a short position in the EUR versus the USD.
The ECB considers a weaker exchange rate as one of the key channels to support growth; as such, the EUR’s decline is likely to accelerate in the next couple of months.
We also think euro zone banks would be the first to benefit from the ECB’s QE programme. This is why we are overweight investment-grade bonds in the financial sector. We are neutral on other investment-grade and high-yield bonds – we don’t think investors are sufficiently compensated for the market liquidity risk after a bout of volatility in September and October, even though default rates remain historically low.
The case for QE
Sceptics of QE may say the ECB may buy time by adding layers of private debt onto its balance sheets, such as corporate bonds, before resorting to sovereign bond purchases. Buying corporate bonds would be a step in the right direction, but not a big enough one for the ECB to achieve its target for balance sheet expansion.
Assuming the ECB limits its buying to securities already deemed acceptable as collateral security for repo transactions, the size of the eligible market would be around €500bn. To counter any serious price distortions, the ECB would only be able to buy 10-30% of that over the next couple of years – or around €50-150bn.
Eventually, the ECB will have to start buying sovereign bonds. The need for such action is becoming ever more urgent. One major worry is persistently weak loan-making to businesses. While the ECB’s health checks showed the region’s top lenders have substantially strengthened their balance sheets, banks are unlikely to jump into lending anytime soon. This is partly because regulators demand banks build additional capital to enhance financial stability, through measures such as Basel III, Dodd-Frank and derivatives reform.
Another fear is that low inflation turns into Japanese-style deflation. The euro zone 5-year 5-year forward breakeven rate – a gauge of the market’s inflation expectations closely monitored by the ECB – has been edging downwards, having fallen below the 2% level earlier this year. Tellingly, this is the level that prompted the Fed to implement its own QE.
An additional headache for the ECB is that it can no longer rely on the Fed to dig it out of a hole – the US central bank is poised to raise interest rates at some point in 2015.
We think the ECB is likely to buy sovereign debt according to the so-called “capital key” – or in proportion to the size of the euro zone’s 18 economies – to keep the QE within its mandate and legal framework.
That would mean roughly 18% of any money spent would go on German bunds, 14 % on French bonds and 12 and 8% on Italian and Spanish paper.