Euro-Region Bonds Set to Lose Key Buyer as ECB Tapering Looms

Updated on
  • Money managers expect little from ECB decision on July 20
  • Peripheral bonds set to lose with Italian elections in 2018

European Central Banks Watch ECB for Policy Clues

Euro-area government debt may be about to lose its biggest supporter.

Money managers at Standard Life Investments Ltd., JPMorgan Chase & Co. and Aviva Investors are avoiding euro-region bonds as the European Central Bank moves closer to winding down its extraordinary quantitative-easing measures. While not much is expected from the ECB’s latest policy decision due July 20, many investors forecast an announcement of tapering in either September or October.

“European debt is more susceptible to a benign repricing and higher yields,” said Jack Kelly, an Edinburgh-based money manager at Standard Life Investments, which is underweight core European debt. “The political risks are in remission, the growth numbers and particularly confidence data are positive. It seems unrealistic that the ECB won’t use this is an opportunity to re-calibrate and take policy off emergency levels.”

Euro-area bonds have sold off since ECB President Mario Draghi said on June 26 at the central bank’s forum in Sintra, Portugal, that reflationary pressures had replaced deflationary ones on the continent. Benchmark German 10-year bund yields climbed last week to the highest level since January 2016, with their European counterparts mirroring the move higher.

Political risk also helped boost the haven appeal of government bonds over the past year, with investors buying German bunds before elections in France and the Netherlands. For now at least, political premiums have dissipated as the threat of electoral upset has diminished.

Yield Spreads

Instead, money managers are positioning for a widening in yield spreads in countries such as France, Spain and Portugal -- which have narrowed to yearly lows as the ECB poured money into the bond market.

“We are underweight duration overall in Europe,” said Seamus Mac Gorain, a London-based portfolio manager at JPMorgan Chase Bank, which has been looking for value in countries such as Australia and Slovenia. “There’s always this bid from the ECB helping to keep spreads in check.”

The ECB began its asset-purchase program in March 2015. At its policy meeting last December, Draghi announced a reduction in monthly bond purchases to 60 billion euros ($69 billion) from 80 billion euros starting in April this year.

With growth in Europe picking up to 1.9 percent, its strongest since December 2015, the remaining doubts surround whether inflation will meet the ECB’s goal of below, but close to, 2 percent. The central bank forecasts that annual consumer prices will rise 1.3 percent in 2018 and that figure could come under pressure as low oil prices and a strong euro mean imported prices increases are stifled.

German 10-year bund yields were at 0.56 percent as of 8:29 a.m. in London, having climbed to 0.62 percent on July 12. They are predicted to rise to 0.65 percent by year-end, according to the weighted-average forecast in a Bloomberg survey of analysts. Comparable Italian bonds yielded 2.19 percent.

Capital Key

Italy’s bonds may stand to lose the most from a tapering in QE. While the ECB has consistently bought above its capital key in the nation’s debt -- as well as France and Germany -- the risk of a populist victory in next year’s elections could exacerbate any sell-off.

Aviva Investors is particularly pessimistic about the outlook for peripheral bonds as stimulus is scaled back, leaving a shortage of demand.

“Looking at the ownership structure it’s not clear to us who the marginal buyer of peripheral risk is in a post-QE world,” James McAlevey, a money manager at Aviva in London, wrote in emailed comments. “We have limited conviction that the spreads or yields on offer are at a sufficient level to compensate for these issues yet.”

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