As recently as Autumn 2018, European investors seemed to be preparing their fixed income portfolios for an imminent rise in bond yields.
The European Central Bank (ECB) formally ended its €2.6bn quantitative easing programme in December and a rate rise looked highly likely towards the end of the summer this year. But in a few short months that narrative has changed.
“The landscape in the eurozone has changed dramatically,” said Kevin Flanagan, senior fixed income strategist, at ETF specialist Wisdom Tree. “At this this stage, a rate hike from the ECB in 2019 looks very unlikely.”
Underpinning this shift has been a sharp reverse in economic data. Fears of a slowdown in the eurozone have risen after its economy stagnated at the end of 2018, growing just 0.2% between the third and fourth quarters.
Italy’s economy meanwhile tipped into recession. The German government has slashed growth projections this year to 1% from 1.8% dashing hopes that economic weakness in Europe’s largest economy was down to one-off factors such as new EU emissions standards hitting auto manufacturers.
In January, Eurozone Purchasing Managers Indices data fell to 50.7 – not only the lowest reading since August 2013 but also perilously close to the 50.0 level, or the threshold considered the arbiter between contraction and expansion.
The ECB’s Bank Lending Survey also pointed towards softening demand for credit from both the consumer and business sectors.
Rate rises on hold
“Any consideration that the ECB may have had about raising rates in 2019 has been put on the backburner,” Flanagan said.
ECB president Mario Draghi has signalled that the bank will act in the event of a prolonged slowdown but is unlikely to restart quantitative easing (QE). Additional central bank action, therefore, could involve halting the pace of reinvestments of QE bonds as they mature.
“Any action is likely to involve the ECB reinvesting any maturing or redeemed bond proceeds,” Flanagan added. “There are lots of mechanisms they could use to try and normalise the balance sheets.”
“While the policymakers have yet to formally alter their forward guidance, it seems increasingly apparent that there will be no rate hike in 2019, a sentiment echoed in the futures market.”
Wisdom Tree said it could foresee the 10-year German bund yield trade in a 0.30% to 0.65% range. The trendline over the last two years places the level a little over 0.40% (see chart).
Change at the top
Adding to the uncertainty, ECB president Mario Draghi is set to step down at the end of his eight-year term at the end of October.
The eurozone comprises 19 integrated but independent economies with separate banking systems and Draghi’s time at the helm has been defined by his steadfast commitment to stabilising the euro following the financial crisis. Draghi’s successor will inherit a plan to gradually unwind those measures and rebuild the buffers before the next downturn, which now looks like it might come sooner rather than later.
Finnish central bank chief Erkki Liikanen and French central bank governor Francois Villeroy de Galhau are among the names in the frame to succeed him.