Europe’s bond markets are preparing for the European Central Bank (ECB) to call time on the quantitative easing (QE) bond-buying program aimed at boosting Europe’s sluggish economy. With the economy now in much better shape, there are growing expectations that the ECB will start to wind down—or taper—QE soon.
QE buying has had a huge impact on Europe’s bond markets. It’s resulted in low to negative yields in the safest bonds, spread compression across the euro-area’s different government bond markets, tighter credit spreads and a general flattening of regional yield curves.
The ECB will plan its taper strategy carefully to try to avoid messy and sudden reversals of these dynamics. But markets are already trying to get ahead of the policy curve and to price in QE tapering well before it begins. The adjustment process is likely to pick up pace over the summer.
What should bond investors expect?
Bund prices will move most. The vast majority of QE buying has targeted European government bonds and the ECB has bought more Bunds than any other government paper—well over €30 billion to date. And this has driven Bund yields way below their fair value. The last few months have seen modest Bund repricing, but we expect more. Indeed, some longer-dated Bund yield could rise by as much as 1%.
The spread between euro-area countries’ borrowing costs (as measured by their government bond yields) could widen. This shouldn’t trigger another full-blown regional sovereign debt crisis because peripheral credit spreads are unlikely to get anywhere near crisis-level wides, unless the region gets hit by severe political shocks. In addition, the improving economic backdrop means much of the periphery is now a lot more resilient and better able to weather modestly higher borrowing costs.
Regional credit will benefit from supportive demand dynamics. Negative interest rates and QE have encouraged investors to move their money out of the safest government bonds and into higher-yielding assets, ensuring that demand for regional credit has comfortably outstripped the available supply.
This has provided an important technical support for credit and it’s a trend that been gaining extra impetus since the ECB began to include some corporate bonds in QE buying since last spring. We’re not expecting this tailwind to change course—not least because the credit supply could get more constrained in coming months. Lots of companies have been scrambling to get their long-term borrowing in place well ahead of the QE cut-off so issuance could tail off later this year. Although interest rates might start to move higher at some stage, this is likely to be a slow process—meaning that cash will remain an unattractive investment.
Positive fundamentals should help keep a floor under regional credit. As a whole, Europe’s corporate borrowers are in good shape. They aren’t overloaded with debt and their businesses should benefit from the improving regional economy. The euro currency is likely to gain ground as tapering nears—and we think a stronger euro will continue to attract foreign investors. This suggests most corporates will have ample buffers to withstand modestly higher modestly higher borrowing costs in a post-QE world—and this should help keep default rates low.
In the more than two years that ECB QE has been in place, it’s touched most corners of regional bond markets. Well-prepared bond investors should recognize that its phase-out could prove similarly pervasive. .
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.