Weakening Growth Outlook to Eventually Favor Euro Rate Risk

17 January 2023

3 min read

John Taylor| Head—European Fixed Income; Director—Global Multi-Sector

Nicholas Sanders, CFA| Portfolio Manager—Global Multi-Sector

European policymakers face a dilemma: continue to hike interest rates to combat inflation or ease off to stimulate growth. Across Europe, headline inflation has started to fall while the growth outlook remains weak. That combination would typically limit the scope for future rate rises and favor increased exposure to interest-rate risk (duration). We believe investors should prepare to back the beneficiaries of lower euro rates—but hold off taking big interest-rate risk positions for now.

We expect rates to stabilize in the second half of this year and fall later in 2023 or early 2024. Bond market prices will likely anticipate the changes, rewarding investors who have positioned their portfolios appropriately. But in the short term, there are several factors that urge caution before taking aggressive rate positions.

ECB Remains Under Pressure to Stay Hawkish

Despite falling headline numbers, core inflation in the euro area remains high, which will likely keep the European Central Bank (ECB) hawkish. And from a technical perspective, both UK and euro-area governments’ funding needs are rising, resulting in much higher sovereign-bond issuance (Display).

Sovereign Bond Issuance Is Rising Sharply Across Europe

Several Factors Are Driving Unprecedented Annual Net Supply

Across Europe and the UK net issuance is surging in 2023 to a forecast €718 billion and £228billion respectively.

Current and historical analyses do not guarantee future results.
As of January 10, 2023
Source: BoE, ECB and Goldman Sachs

This coincides with the end of quantitative easing (QE) and the start of quantitative tightening (QT), increasing the publicly available supply of bonds to unprecedented levels and creating uncertainty about how markets will digest the elevated volume, particularly in the 20- to 30-year part of the curve.

Overseas buyers’ reduced appetite for euro sovereign issues is a further potential concern. Notably, the Bank of Japan’s recent adjustment to their yield-curve control (YCC) policy has increased the yields of Japanese government bonds (JGBs) and reduced the attractiveness of overseas bond markets to Japanese investors—particularly on a currency-hedged basis (Display). It would take higher yields to make euro sovereign bonds attractive for Japanese investors. Thus, although European sovereign-bond yields have already risen meaningfully, we think there are still grounds for caution in the short term.

Japanese Bond Investors Are More Likely to Stay at Home

Overseas Bonds Are Less Attractive When Hedged to Japanese Yen

30-year JGBs yield 1.7%, much more than UK Gilts, German Bunds, French OATs and even US Treasuries hedged back to yen.

Current and historical analyses do not guarantee future results.
As of January 10, 2023
Source: Bloomberg

However, we do think that as the year progresses—and probably not too far into the year—it may be an attractive time to lengthen duration in Europe, as the battle between growth and inflation will likely tilt to make the growth slowdown the dominant factor.

Sovereign-Bond Sensitivity to Rate Hikes Varies

Sovereign-bond valuations across the European periphery have realigned, with several countries now perceived as stronger issuers than in recent years. Spain and Ireland’s status has improved, and their bonds are now trading more in line with French government bonds (OATS). Portugal is slightly more highly rated than Italy, while Greece, after demotion in 2010, is set to return to investment-grade status and is already trading at a lower yield level than Italy. That leaves Italian government bonds (BTPs) as the standout potential beneficiary from policy easing.

And while, in our analysis, BTPs have the most price upside potential, their potential downside has also been moderated by the ECB’s recently-introduced transmission protection instrument (TPI), a program that may help prevent peripheral countries’ spreads widening too far from German Bunds.

Recently, we have seen BTP spreads over Bunds ranging between 100 and 200 basis points, depending on the extent of TPI intervention. But our research suggests that BTP spreads may widen as Bund yields rise and narrow as Bund yields fall. This makes BTPs more sensitive to rate changes than their German counterparts, and so potentially attractive to shorter-term investors with a higher risk tolerance.

In the lower-risk part of the market, 10-year Bund yields rose to around 2.6% in October 2022 and then retraced to a little below 2.2% this year. We see a 2.5%–3% yield range as an attractive Bund level for longer-term lower-risk investors.

We think investors can consider a duration game-plan in terms of time frame: shorter term, be more cautious, but over the coming quarters, look to increase interest-rate risk. And be mindful of which sovereign bonds will be most sensitive to euro rate changes and most appropriate for their particular risk tolerance.

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. Views are subject to revision over time.

About the Authors

John Taylor

John Taylor is Head of European Fixed Income and Director of Global Multi-Sector at AB. He is a senior member of the Global Fixed Income, UK and European Fixed Income, and Absolute Return portfolio-management teams. Prior to this, Taylor was responsible for the management of single-currency portfolios. He joined the firm in 1999 as a fixed-income trader and was named in Financial News’s 40 Under 40 Rising Stars in Asset Management in 2012. Taylor holds a BSc (Hons) in economics from the University of Kent. Location: London

Nicholas Sanders, CFA

Nicholas Sanders is a Vice President and Portfolio Manager at AB, and a member of the Global Fixed Income, Absolute Return, UK Fixed Income and Euro Fixed Income portfolio-management teams. Since 2013, he has been responsible for the analysis of sovereign and other liquid markets globally, with a focus on the European market. Prior to that, he worked as an associate portfolio manager on the Asian Fixed Income team, where he was responsible for analysis of and trade execution for local and global fixed-income markets. Sanders joined AB in 2006, and served as team leader of Servicing & Controls within the Australian & New Zealand Operations Group. Before joining the firm, he worked in both Australia and London as a pricing and valuation analyst. Sanders holds a BBus in economics and finance from the Royal Melbourne Institute of Technology (RMIT) and is a CFA charterholder. Location: London

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Weakening Growth Outlook to Eventually Favor Euro Rate Risk

ECB Remains Under Pressure to Stay Hawkish

Sovereign-Bond Sensitivity to Rate Hikes Varies

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