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04 Jun 2018

Europe’s policy storm: what it means for your bond investments

In early 2018, as we looked down the road ahead, we expected to see rising US yields, and – with a lag – a similar dynamic in Europe. Indeed, because of the strong economic momentum in the US, Treasury yields have been rising. But now, Europe’s path is taking a different turn.

Political turbulence in Italy has pressured Eurozone bond yields. And to some, seeing the two-year Italian bond yield spike 35 basis points in one day rang unpleasant echoes of 2011-2012. At that time, in the wake of the Global Financial Crisis as Eurozone economies experienced widening deficits and were pressed to tighten their fiscal belts, the region dipped again into recession. This sparked a sell-off in sovereign debt in the periphery economies.

But we believe that we’re treading a very different path today. By mid-2016, Italy’s and Spain’s spreads over German bunds were neck and neck. But Italy’s spreads are now twice as high as Spain’s, whereas 2012’s sell-off was more uniform.

Markets are presently far more discriminating, with investors judging individual markets on fundamental metrics. Moreover, while fear that the Eurozone might fall apart drove the 2012 sell-off, this time it’s Italy’s specific situation that’s pushing up risk.

Political turbulence in Italy has hit the eurozone bond market in recent weeks 

                           chart 1

Source: Lyxor International Asset Management, ThomsonReuters Datastream. Data as at 30/05/2018 Past performance are not reliable of future performances. 

Could the Italian political storm put the eurozone itself at risk?

It’s certainly concerning that Italy’s traditionally pro-European population has turned increasingly Eurosceptic. Both La Lega and its coalition partner, the Five Star Alliance want to challenge the European Union, and spending promises in their manifesto would almost certainly break EU fiscal rules.

So far, the spread of contagion to Portugal, Spain or Greece has been more limited. Albeit Spain is suffering from its own problems, with its Prime Minister forced out of office by a no confidence vote in parliament on Friday 1st June. Mariano Rajoy's government is thus being replaced by a minority government led by PSOE's Pedro Sanchez. With less than a quarter of the seats in the lower house, political instability and inaction is likely.

The relative resilience of these other markets also suggests that countries that received financial assistance (either fully or only for their financial sector) may be on a better footing today (both in terms of public finances and economy growth) and are arguably better able to cope with another bout of market stress. 

In our view, the real make-or-break situation doesn’t lie in the future with Italy. Rather, it’s already happened – with Greece.

For Greece to have left the Union would have opened Pandora’s Box. But it is Mario Draghi’s forceful July 2012 statement that remains with us today: “The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Whether the ECB would have made another similar statement today is debatable. 

US and Europe on diverging paths

Both on the short-end and the long-end of the yield curve, the gap between the US and the Eurozone is already widening; in the near term, we expect this to continue. In addition to benefiting from fiscal stimulus and high exposure to rising oil prices, the US economy is operating at full capacity and inflation is likely gain pace further.
So three more rate hikes may well be on the cards for 2018.

>>View our US Floating Rate Note ETF

Europe is still experiencing relatively high growth, with the region’s economy firmly in expansionary territory. But inflation is still below expectations, and the ECB is rightfully expressing a dovish monetary stance. We believe refinancing rates are not going to move higher before H2 2019, as the shift in monetary policy will be very gradual.

Ultimately, the market deems it unlikely that Italy will opt to leave the EU, and Italian spreads have already eased down somewhat. However, this problem isn’t about to go away. We expect the political situation in Italy to generate protracted uncertainty, with spreads remaining elevated compared to their early-2018 levels.

So, for now, the paths diverge. But we maintain our conviction – and our hope – that the Eurozone moves forward as one.

Options left to fixed income investors

We believe investors have a number of options in this environment. The natural choice might be to look to peripheral European economies where yields are higher and appear to give some insulation. However, these are higher risk and there may be contagion if the problems in Spain and Italy escalate. As such, the protection is likely to be limited.

If the situation in Italy gets worse, few Eurozone fixed income markets will escape the turmoil, the highest rated market would prove more resilient. Another way to avoid it may be to look outside, like US Treasuries. The UK is also often ignored in this context, yet UK bonds are paying a much higher yield than Germany (1.26% versus 0.37% - Source: Bloomberg to 30 May 2018).

Investors can also look to go short the fixed income market. This helps those who are mandate-constrained and need have a fixed income allocation.

Looking ahead, the combination of political turmoil and changing sentiment from the ECB can only be a recipe for higher yields for non-core sovereign bonds whereas German Bund 10 year yield has dropped below 0.5%. This is an uneasy time to be a Eurozone fixed income investor.

>>Find out more about Lyxor’s European Government and Corporate bond funds

All views & opinion, Lyxor Equity & SG Cross Asset Research/ Equity Quant team, as at 30 May 2018 unless otherwise stated. Past performance is no guide to future returns

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*Source: Lyxor International Asset Management. Data as at 31/01/2018. Statements refer to European ETF market.

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