Over recent weeks, European fixed income markets have been performing relatively well on balance. Issues including geopolitical risks, shifting expectations on US yields and concern on growth in emerging markets have not had any major impact. The main theme driving returns is the perception that the European Central Bank (ECB) is getting closer to adopting extraordinary Quantitative Easing (QE) measures to provide support to the timid economic recovery.
The benchmark 10-year German Bund yield has dropped by some 40bps (currently around 1.54 per cent) so far this year, reflecting the expected downward pressure on rates. Movements in bonds from peripheral countries have been particularly impressive. Yields on sovereign bonds from countries including Spain and Italy are at multi-year or record lows. Spreads over German debt have compressed considerably – possibly beyond what can be justified by any improvement in fundamentals.
Expectations for QE in the eurozone have been gathering momentum. An increasingly-dovish position by the ECB is filtering through its statements and comments. In particular, there is concern relating to persistently-low inflation and the impact of a strong euro currency on the very modest economic recovery.
During meetings at the International Monetary Fund some weeks ago, ECB President Mario Draghi referred to an expected period of prolonged low inflation (currently at 0.5 per cent). He also noted that exchange rate developments and geopolitical risks are being monitored attent-ively and did not exclude further monetary easing.
In reality, it seems that the focus of financial markets is already shifting to the timing of QE and to which specific QE measures will be adopted by the ECB. It is likely that the Central Bank will wait until June, with an improving economy possibly resulting in an uptick in inflation by then. A Bloomberg survey showed that two-thirds of participants expect Draghi to ease monetary policy by mid-year.
Meanwhile, there are indications that the ECB is busy working on assessing the feasibility of various QE options. In early April it was revealed that the ECB is running QE simulations and modelling the impact of up to €1 trillion in bond purchases.
Beyond another interest rate cut, possible measures could include further bond purchases or the elimination of the process whereby the liquidity created from crisis-era bond purchases is absorbed through deposits (or ‘sterilisation’). Other measures being suggested are negative deposit rates for banks, or a new round of long-term loans to the banking system.
A possible focus on purchases of asset-backed securities (ABS) is attracting much attention. An ABS is a securitised investment security backed by a pool of underlying assets that could include several types of loans, credit card debt, leases, receivables and royalty payments.
The idea is that this option would be suitable to specifically boost the flow of credit in the eurozone economy. Notably, Ewald Nowotny, the Austrian member of the ECB’s Governing Council, has expressed his pre-ference for this option. It is relevant to note that buying sovereign bonds would encounter several obstacles because the ECB is not allowed to finance government deficits.
On the other hand, the ABS option is not without limitations. The size of the European ABS market is relatively small. Bloomberg recently reported that according to the Association for Financial Markets in Europe, total issuance of securitised assets in Europe was €251 billion in 2012, compared with the equivalent of €1.55 trillion in the US.
Additionally, EU regulations on such instruments would likely need to be changed, and this may take some time. ABS are relat-ively complex securities. Ironic-ally, while ABS are being promoted as potentially useful QE tools, they were often blamed for triggering the financial crisis.
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This article is the objective and independent opinion of the author. The information contained in the article is based on public information.
Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Karl Falzon is a credit analyst at Curmi and Partners Ltd.