Bond investors seeking to avoid the first successive losses on Treasuries in at least 35 years are finding shelter in Europe.
Yields on 10-year U.S. government debt are estimated to rise more than a half-percentage point next year to 3.38 percent, which would result in a loss of 1.6 percent, according to data compiled by Bloomberg. Yield forecasts for Spain and Italy, where borrowing costs soared to more than decade highs during the European debt crisis, indicate bond returns in 2014 will extend this year’s gains of as much as 11.1 percent.
With the Federal Reserve taking its first step last week to unwind its unprecedented stimulus, Robeco Groep NV, Fidelity Investments and Amundi are venturing into developed nations hit hardest by the crisis as confidence builds in European Central Bank President Mario Draghi’s ability to safeguard the 17-nation currency bloc. Bonds from Spain to Italy and Ireland posted the world’s biggest gains and the euro rose against the most-traded currencies. Longer-dated Treasuries had the deepest losses.
“Europe may not be perfect and there are still a lot of issues, but we don’t expect the euro crisis to flare up again,” Kommer van Trigt, the head of fixed-income at Rotterdam-based Robeco, which oversees about $260 billion, said in a Dec. 19 interview. “We expect the ECB to remain in the easing mode while the Fed starts tapering. Against this backdrop, we are more constructive on European bonds relative to Treasuries.”
Seventeen months after Draghi pledged to do “whatever it takes” to keep the euro area from fracturing, the region’s bond, currency and derivatives markets all suggest the contagion that engulfed the continent starting in 2009, pushed Greece into default and hobbled economies including Spain and Italy, has finally started to abate.
Borrowing costs in the most-indebted nations, which were targeted as bondholders questioned the sustainability of their finances and ability to keep the euro, are falling as they push through deficit-cutting measures and after the ECB committed to unlimited bond purchases to stabilize the economies.
On Nov. 7, Draghi also reduced the ECB’s benchmark interest rate by half to a record 0.25 percent, the third such reduction since July 2012. The bank “continues to expect its key ECB interest rates to remain at present or lower levels for an extended period of time,” Draghi said Dec. 5 after leaving the benchmark rate and the zero-percent deposit rate unchanged.
“What was a very vicious cycle has turned into something quite virtuous,” Nicholas Gartside, London-based international chief investment officer for fixed-income at J.P. Morgan Asset Management, which oversees $1.5 trillion, said by telephone on Dec. 11. “Europe had very weak public finances, bank fragility and sovereign stress. The ECB has done well in addressing those issues. Europe is no longer falling off the cliff.”
Government debt in Spain returned 11.1 percent this year through Dec. 20 and is poised for the biggest advance since 1998, index data compiled by Bank of America Merrill Lynch show. Yields on the nation’s 10-year bonds have plunged by more than 3.5 percentage points since surging to 7.75 percent in July 2012, the highest since 1996. They ended at 4.21 percent yesterday. Trading of euro-area securities was closed today for the Christmas holidays.
While forecasters anticipate that yields on the notes will increase 0.12 percentage point next year to 4.37 percent as Europe recovers, the projection implies a return of 3.4 percent, data compiled by Bloomberg show.
Yields on Italian 10-year bonds, which were at 4.18 percent yesterday, are forecast to be unchanged in 2014 and end at 4.28 percent. That would extend annual gains to a third year. Italian government notes have returned 38 percent since average yields peaked at a 14-year high of 7.75 percent in November 2011, index data compiled by Bank of America show.
“Now that we are in an environment where the crisis is not as acute, the need to hold the lowest-yielding flight-to-quality asset isn’t there to the same degree,” Jamie Stuttard, London-based head of international bond management at Fidelity, which oversees $1.7 trillion, said in a Dec. 10 telephone interview.
Returns have been amplified as the euro appreciated against 15 of the world’s 16 other most-traded currencies this year, the broadest advance since its inception in 1999, data compiled by Bloomberg show. The 3.8 percent rally against the dollar through yesterday is also the biggest since 2007.
While investors are showing renewed confidence in euro-area bonds, the challenges that remain may hold back further gains in the region’s debt securities. Debt ballooned to 93.4 percent of euro-area economies at the end of June, the highest since the introduction of the euro, and climbed to 133 percent in Italy, according to data from Luxembourg-based Eurostat, the European Union’s statistics office.
The jobless rate in the euro area will reach 12.1 percent this year and remain at that level next year, which would be the highest since at least 1991, according to economists surveyed by Bloomberg, while debt in most euro-zone countries remain well above the limits set for membership in the single currency.
Disinflation, which can cause consumers and businesses to put off spending, also risks becoming entrenched in Europe. The region’s inflation rate stayed below 1 percent for a second month in November, less than half the ECB’s ceiling. As recently as November 2011, euro-zone inflation was 3 percent.
The cost of insuring against deflation, which would increase the value of debt and servicing costs, in the euro area for two years reached a 17-month high this month.
Without a pick up in economic growth that’s forecast to reach just 1 percent next year -- or less than half the 2.6 percent estimate for the U.S. -- Europe’s most-indebted nations are still vulnerable, according to Dario Perkins, a global economist at Lombard Street Research in London.
“The optimism about the euro region’s outlook is probably overrated as there are still fundamental imbalances,” he said in a Dec. 20 interview. If the economy stagnates and unemployment remains high, “that could undermine the region.”
Currency forecasters are also showing their skepticism. The euro, valued at $1.3696 yesterday, is projected to slide to $1.28 by the end of next year and weaken against 14 of the 16 other major currencies, according to the median estimate of 84 economists and strategists surveyed by Bloomberg.
The decline may wipe out next year’s projected returns for euro-denominated debt for many foreign bondholders when converted back into their local currencies such as the dollar.
Euro skeptics risk being overly bearish as the region’s economies recover and the risk of collapse recedes, according to Axel Merk, who oversees $450 million as the head of Palo Alto, California-based Merk Investments LLC.
At the start of the year, the euro was forecast to weaken to $1.27 from $1.3193 at the end of 2012, according to data compiled by Bloomberg. Westpac Banking Corp., the most-accurate foreign-exchange forecaster for 13 major currencies in the six quarters ended in December 2012, also missed by predicting in January the euro would weaken to $1.27 by year-end.
“The euro-weakness pundits will yet again be wrong,” Merk said in a telephone interview on Dec. 19. “Most importantly, risk in the euro zone is now priced locally, with the threat of contagion greatly diminished, so a problem in a euro-zone country does not equate to euro weakness.”
In the U.S., borrowing costs are forecast to increase as the Fed scales back its easy-money policies after inundating the economy with more than $3 trillion since 2008 to support growth, which may deepen losses in Treasuries next year.
Yields on 10-year Treasuries, which have surged more than a percentage point this year, are projected to end the year at 2.83 percent and then rise to 3.38 percent in 2014, data compiled by Bloomberg show. The increase would translate into a loss on the notes next year and add to this year’s decline of about 7 percent, Bank of America index data show.
The 10-year yield rose five basis points to 2.98 percent at 11:37 a.m. New York time.
Treasuries have never fallen in consecutive years, based on annual return data starting 1978 from Bank of America.
The longest-dated U.S. debt has declined an average 10.6 percent this year, the most among the 144 government bond indexes globally compiled by Bloomberg and the European Federation of Financial Analysts Societies.
The Fed announced plans last week to cut its monthly bond buying to $75 billion from $85 billion. Economists estimate the central bank will pare its purchases by $10 billion in each of the next seven meetings before ending the program in December 2014 as the economy strengthens and joblessness declines.
The world’s largest economy grew at a 4.1 percent annualized rate in the third quarter, a Commerce Department report showed last week, a faster pace than previously estimated, as consumers stepped up spending on services such as health care and companies invested more in software.
The expansion was the strongest since 2011 and exceeded the median 3.6 percent forecast in a Bloomberg survey. The jobless rate dropped to 7 percent in November, a five-year low, as employers added a greater-than-forecast 203,000 workers to payrolls last month.
“Growth and monetary policy are both hinting toward higher rates in the U.S.,” Ralf Schreyer, co-head of global fixed-income at Frankfurt-based Deutsche Asset & Wealth Management, said in a telephone interview on Dec. 9.
Bond investors are signaling increased confidence in the creditworthiness of European nations, based on prices of credit-default swaps.
The cost to protect holders of Spanish and Italian government bonds against nonpayment for five years using the swaps has decreased about twice as fast as the average for investment-grade nations in Europe, according to data provider CMA, which is owned by McGraw Hill Financial Inc. and compiles prices quoted by dealers in the privately negotiated market.
Since July 2012, when speculation deepened that Spain would be forced to seek a sovereign bailout, the cost of the contract has fallen more than 75 percent.
European stocks are also poised for a third year of gains, restoring almost all the losses suffered during the financial crisis. Equities will rise 12 percent in 2014, according to the average projection of 18 forecasters tracked by Bloomberg News.
Italy and Spain will expand for the first time in three years in 2014, growing 0.5 percent and 0.6 percent, according to economists surveyed by Bloomberg. Ireland’s economy will grow by the most since 2010, while Portugal’s three-year contraction will end next year, the estimates show.
“We are overweight in our portfolios on the euro peripheral markets,” Eric Brard, the Paris-based global head of fixed income at Amundi, which oversees about $1 trillion, said in a telephone interview on Dec. 13. “That’s one of the themes that we have. We have a preference for markets that we expect to improve in terms of fundamentals.”