For investors in the euro area’s $1 trillion government bond market, the takeaway from Mario Draghi’s extraordinary stimulus plan is that interest rates are going to stay lower for much longer.
From France to Portugal, five-year notes led the way as yields across the region plunged to records in the wake of the European Central Bank President’s unprecedented package of measures designed to boost the economy. Italy’s five-year rates fell to the lowest level relative to two- and 10-year yields in the history of the euro area, a sign that investors were adding to bets that borrowing costs would remain locked down by the ECB until almost the end of the decade.
“The ECB measures strengthen forward guidance and push out the first hike even further, which has the biggest impact on five-year yields,” Ruediger Kerth, a Frankfurt-based money manager at Union Investment GmbH, which oversees the equivalent of $287 billion, said in a June 10 phone interview. “With the assurance that the ECB will stay expansive over the next years, that is an invitation to sell the short maturities and to invest in the longer ones, in the sector of five-to-seven years.”
Powerful Cocktail
The bond market’s reaction shows the ECB’s cocktail of stimulus measures is its most enduring yet, surpassing 1 trillion euros ($1.4 trillion) of three-year loans when Draghi took office in 2011 and his pledge last year to hold down rates for an extended period. It’s driving down yields in the 18- nation currency bloc while those on U.S. Treasuries and U.K. gilts increase on speculation their central banks are moving closer to raising interest rates.
The June 5 measures included cutting the main refinancing rate to a record 0.15 percent and moving the deposit rate below zero. The central bank will also introduce targeted loans to encourage banks to lend and it will start work on potential purchases of asset-backed securities.
“What’s clear is that for a very long period, several years, monetary conditions will be divergent in the euro zone on one hand and in the U.S. and the U.K. on the other,” ECB Executive Board Member Benoit Coeure said on France Inter radio on June 7. “We’ll keep rates close to zero for an extremely long period. That’s a decisive factor for market actors.”
BOE Contrast
Bank of England Governor Mark Carney said late yesterday that an increase in U.K. interest rates “could happen sooner than markets currently expect.” The pace at which rates rise would be “gradual and limited,” he said in the annual Mansion House speech in the City of London financial district.
The yield on five-year U.K. government bonds jumped eight basis points, or 0.08 percentage point, to 2.08 percent at 9:49 a.m. London time, and reached 2.10 percent, the highest level since July 2011.
With two-year yields already depressed and 10-year yields more vulnerable to a pull upward from rates on similar-maturity Treasuries, the euro region’s five-year notes were best-placed to benefit from Draghi’s package, according to Allan von Mehren, chief analyst at Danske Bank A/S in Copenhagen.
Italy’s so-called butterfly spread, which measures five- year yields relative to two- and 10-year rates, was at minus 56 basis points today, from minus 35 basis points the day before last week’s ECB meeting, reflecting increased demand for the 2019 debt. The spread narrowed to minus 65 basis points on June 9, the lowest since the euro’s introduction in 1999, according to closing prices.
Spain’s narrowed to minus 73 basis points on June 9, from minus 48 basis points on June 4, and Portugal’s narrowed to minus 16 basis points from positive 42 basis points.
Bondholder Boon
“We like the short end of the peripherals market,” David Tan, global head of rates at J.P. Morgan Asset Management in London, said, referring to bonds due in three to five years. The targeted loans and “forward guidance also suggest that the short-end will benefit most from central bank support.”
J.P. Morgan had $1.6 trillion in assets under management at the end of 2013.
The rally is a boon for holders of the government bonds. Greece and Portugal led euro-region securities to a 6.4 percent return this year through yesterday, versus 2.9 percent for Treasuries, according to Bloomberg World Bond Indexes.
The yield on Greek five-year bonds, which were issued at 4.95 percent in April, plunged to as low as 3.83 percent on June 10, and was at 4.09 percent today. Portuguese five-year notes closed at a record-low 2.10 percent on June 9, while France’s dropped to 0.55 percent on June 6.
Negative Rates
The bond rally is helping reduce borrowing costs as countries seek to fund deficits that widened during the sovereign debt crisis. Italy drew record-low yields as it auctioned 8.5 billion euros of of government debt yesterday.
Euro-region banks may purchase so-called core government bonds in order to avoid the ECB’s imposition of charges on deposits made at the central bank, London-based UBS AG interest rates strategist Justin Knight wrote in a June 11 note. German five-year bond yields may fall to 0.33 percent, he wrote. The bonds yielded 0.40 percent today.
That’s likely to be the case, according to ECB Governing Council Member Luc Coene. Lenders’ first reaction was to re- invest withdrawn deposits from ECB into publicly traded bonds, and the ECB expects banks to then gradually increase lending, he told reporters in Brussels yesterday.
Rates Spreads
The prospect of a sustained period of low rates in the currency bloc is being reflected in the spreads between euro- region bonds and those of the U.K. The yield on five-year gilts is now higher than all its similar-maturity euro-area peers apart from Portugal and Greece, according to data compiled by Bloomberg.
“We’ve been positioned for steeper yield curves, preferring bonds that are in the three- to five-year part of the European curve as opposed to the longer dated 10s and 30s,” Phillip Apel, head of fixed income at Henderson Global Investors, which oversees the equivalent of about $133 billion, said in video posted on the company’s website on June 10. A steeper yield curve signifies higher yields for longer-maturity bonds versus shorter-dated debt.
“It’s obviously those intermediate bonds, the three- and five-year maturity, that are benefiting most from the European Central Bank move to a negative interest rate,” he said.
Bloomberg
