Five years ago, ECB President Mario Draghi promised to do "whatever it takes" to save the Euro. In the midst of a sovereign debt crisis that roiled global financial markets, ECB action lived up to the rhetoric. Fueled by an extensive quantitative easing program, European bond prices surged and yields plunged into negative territory. However, in 2017 European growth and inflation finally started to accelerate higher, after years of anemic economic activity.
In an era of uncomfortably high financial asset valuations - European bonds take the cake. Trillions of EUR denominated bonds trade at negative yields - investors pay borrowers to lend them money. These negative yielding bonds are not just government bonds but the debt obligations of corporations too. A few weeks ago, Veolia - a BBB rated water and waste treatment provider issued a 500mm EUR 3 year senior unsecured zero coupon bond priced to yield a negative interest rate at issuance! The European junk bond index yields less than the 10 year US Treasury. Ditto for sovereign 10 year debt in Italy and Spain.
ECB QE inserted a price inelastic structural buyer into European fixed income markets ranging from sovereign debt to corporate bonds. Money managers were able to front run the ECB, driving yields on corporate bonds into negative territory in anticipation prices would continue to increase and yields continue to drop. Despite this capital dislocation, the ECB is likely pleased with the results. Credit growth has strengthened across Europe, unemployment is trending down, GDP and inflation is accelerating in a broad based recovery. Economists expect 10% growth of European capital expenditures in 2018. Given diminishing spare capacity, further inflationary pressure is all the more likely. The EUR strengthened against the USD from 1.03 to 1.20 in 2017, which could weigh on growth as European products become more expensive relative to the rest of the world. However, the European current account surplus recently reached record levels at 4% GDP. Currency strength threatening the recovery is a mitigated concern. The yield spread between German bunds and US Treasuries remains at historic wides. As US growth and inflation prospects tick up across the Atlantic, rising US Treasury yields should propel German bund yields higher and cause the spread to narrow. Political risk may rear its ugly head in March should a euroskeptic party win a mandate in the Italian general elections. Should these drivers persist, European bond yields must rise in tandem - with little or no coupon income to protect investors. Given positive economic developments and hawkish rhetoric in recent meetings, the ECB may end QE purchases in September 2018. Net European bond supply is forecasted to be around +100B EUR this year, which should pressure yields higher as well. A 50 bp sell off in the 10 year German bund would mean a 100% increase in yield. Once this structural buyer of the ECB is removed - there is no good reason to hold European fixed income exposure if you have the choice.
In an era of uncomfortably high financial asset valuations - European bonds take the cake. Trillions of EUR denominated bonds trade at negative yields - investors pay borrowers to lend them money. These negative yielding bonds are not just government bonds but the debt obligations of corporations too. A few weeks ago, Veolia - a BBB rated water and waste treatment provider issued a 500mm EUR 3 year senior unsecured zero coupon bond priced to yield a negative interest rate at issuance! The European junk bond index yields less than the 10 year US Treasury. Ditto for sovereign 10 year debt in Italy and Spain.
ECB QE inserted a price inelastic structural buyer into European fixed income markets ranging from sovereign debt to corporate bonds. Money managers were able to front run the ECB, driving yields on corporate bonds into negative territory in anticipation prices would continue to increase and yields continue to drop. Despite this capital dislocation, the ECB is likely pleased with the results. Credit growth has strengthened across Europe, unemployment is trending down, GDP and inflation is accelerating in a broad based recovery. Economists expect 10% growth of European capital expenditures in 2018. Given diminishing spare capacity, further inflationary pressure is all the more likely. The EUR strengthened against the USD from 1.03 to 1.20 in 2017, which could weigh on growth as European products become more expensive relative to the rest of the world. However, the European current account surplus recently reached record levels at 4% GDP. Currency strength threatening the recovery is a mitigated concern. The yield spread between German bunds and US Treasuries remains at historic wides. As US growth and inflation prospects tick up across the Atlantic, rising US Treasury yields should propel German bund yields higher and cause the spread to narrow. Political risk may rear its ugly head in March should a euroskeptic party win a mandate in the Italian general elections. Should these drivers persist, European bond yields must rise in tandem - with little or no coupon income to protect investors. Given positive economic developments and hawkish rhetoric in recent meetings, the ECB may end QE purchases in September 2018. Net European bond supply is forecasted to be around +100B EUR this year, which should pressure yields higher as well. A 50 bp sell off in the 10 year German bund would mean a 100% increase in yield. Once this structural buyer of the ECB is removed - there is no good reason to hold European fixed income exposure if you have the choice.
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