Linking the weighted-average bond yield to the inflation target is a powerful way for the ECB to justify its bond purchases and its willingness to hold down peripheral bond yields. So much so that it could be a way for the ECB to introduce more explicit yield-curve control in the euro area.
"Whatever It Takes" Commitment Lives On
Ever since Mario Draghi promised to do “whatever it takes to preserve the euro,” the ECB’s willingness to underwrite the sovereignty of all euro-area countries has dominated the outlook for Europe’s fixed-income markets. Despite signs of progress on a European Recovery Fund, it continues to do so today.
The good news is that the ECB’s commitment is as strong today as it was eight years ago. This dual mandate will only face strain when low yields conflict with the inflation target itself. With the ECB’s latest forecasts putting core inflation at just 0.9% in 2022—making a case for even more stimulus later in the year—that’s a very distant prospect.
European Sovereign Bonds Are Still Attractive
At a time when central banks are anchoring yields close to the policy rate and reducing volatility—thus suppressing the return potential from holding sovereign bonds—the ECB’s willingness to stand behind peripheral bond markets continues to make a positive case for European fixed-income markets.
With the ECB transitioning from anchoring German bond yields to reducing the weighted-average euro-area yield by compressing sovereign spreads, government yield curves in Europe are steeper and offer higher hedged yields than in most other developed markets. In a world of lower volatility, those attributes make European sovereign bonds very attractive for global investors.
Our highest conviction is in government bonds with maturities of 10 years or less. That’s because the power of the ECB’s key policy tools—a negative deposit rate and quantitative easing—starts to fade at longer durations, especially when the market is expecting much heavier bond supply. That supply is likely to create upward pressure on longer maturities and keep longer-dated yield curves steeper.
With global bond yields and volatility close to record lows, the best period for government bond returns is probably behind us. But there are still opportunities for active investors, including the relatively high yields still available in the euro-area periphery—and especially in the new era of yield caps and yield-curve control.
