As the ECB starts to scale back quantitative easing, investors are looking to its next move. When might the ECB pull the plug on QE entirely? And how are Europe’s bond markets likely to hold up?
IS THE END NEARER THAN MARKETS EXPECT?
The European Central Bank (ECB) has begun to scale back its big bond-buying program. It’s cut the overall volume of its monthly quantitative easing (QE) purchases from €80 billion to €60 billion as the specter of regional deflation has begun to fade. As Europe’s economic outlook continues (slowly) to improve and inflation builds, the ECB is bound further to taper its remaining monthly purchases—provided the region averts any further big political upsets.
The ECB will try to ensure that QE tapering is both well signposted and gradual. It’s acutely aware that big bombshells can be damaging. When the US Federal Reserve (Fed) startled markets in the spring of 2013 by indicating it was planning to scale back its QE program in the coming months, taper talk triggered a bond market tantrum that saw 10-year US Treasury yields spike by more than 1.3% over the next few months.
The Fed’s experience shows how jittery markets can get at the slightest hint that monetary conditions might tighten at some point. When ECB taper talk begins, bond investors should be braced for volatility. We expect a big rise in government bond yields which could trigger an unwinding of the negative yields that dominate the region’s safest government bonds—and a repricing of credit spreads.
When will this happen? The broad consensus view is that taper talk will begin at the end of this year or early in 2018. We think it could happen much sooner—maybe as early as June, although any actual tapering wouldn’t start until several months later.
Waiting for a clear signal from the ECB could prove costly. Bond investors with Europe-only mandates should start preparing for changing market dynamics now.
DIAL DOWN DURATION
QE has forced investors to take on greater credit risk—and look at longer maturities in order to source higher returns. This demand crushed the yields on the region’s top-rated investment-grade bonds and flattened yield curves. This leaves some long-dated investment-grade bonds looking particularly vulnerable. Investors can position for tapering by selling long-dated bond holdings and buying shorter-duration debt as bond yield curves will steepen as the price of longer-duration bonds falls.
DIAL UP HIGH YIELD
Even if government bond yields rise, we believe the outlook for Europe’s high-yield bonds remains broadly positive. Economic growth is improving, leverage is modest and borrowers aren’t taking on a lot of new debt. Much of the region’s new bond supply is being used to refinance existing borrowing. So default rates are unlikely to rise soon. And high-yield bonds tend to thrive when growth picks up.
CAPITALIZE ON CHANGE
As market dynamics shift, some bond sectors are likely to fare better than others. Europe-oriented bond investors with the freedom to take a highly selective approach across sectors and ratings may be able to position themselves astutely. Likely beneficiaries of a higher-yielding environment include the financials sector, which has seen its profit margins well and truly squeezed by ultra-loose monetary policy. And financials are excluded from ECB QE buying, suggesting they could enjoy extra insulation from any price changes when tapering begins.
It’s just a matter of time before European bond markets face big changes. Instead of second-guessing when the ECB will start turning off the QE taps, we think investors should start bracing their bonds now.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.