European Bonds: Will Cash Stay King as Rates Reverse?

February 09, 2024
3 min read

Investors who stay too long in cash may find they’ve missed out.

A challenging economic backdrop combined with historically high cash yields has driven many investors to favor low-risk, liquid assets such as money market funds (Display). 

Euro Investors’ Dash for Cash
Assets in European Money Market Funds Are at an All-Time High
Assets in European money market funds are at an all-time high, after rising 38% from September 2022 to December 2023.

Current and historical analyses do not guarantee future results.
As of December 31, 2023
Source: Morningstar

Now we believe the balance of risks for euro investors is changing. If you’re among the many investors sitting on the sidelines, now’s the time to get in on the action. Here’s why.

With euro-area inflation easing, rate cuts will likely drive bond prices higher and cash yields lower. Investors bold enough to lock into fixed-income investments now will continue to earn current high income levels and may enjoy capital gains too.

Our analysis—based on a longer US data history—shows that assets tend to flow out of money market funds when the central bank starts to ease monetary policy. On that basis, we believe that euro money-market flows will likely soon reverse as assets are redirected to bond markets. Considering the very large sums involved, the impact on bond prices could be substantial.

Timing Is Critical: Don’t Miss Out

The European Central Bank (ECB) is getting closer to cutting interest rates and has signaled that rate cuts may start in the summer; the market consensus indicates cuts may come as early as April. Timing is important because, historically, bond prices have started to rise ahead of a first rate cut. The investors who made the biggest gains were those who moved early (Display). Investors who stayed on the sidelines, waiting in cash deposits or money market funds until rates changed, missed out on the early gains.

Early Birds Have Captured the Biggest Returns
Average 12-Month Returns (Percent)
Investors who switched from cash to bonds before the first ECB rate cut have made bigger gains than those who delayed.

Past performance does not guarantee future results. 
Average 12-month forward returns of the Bloomberg Euro Aggregate Treasury 5–7 Year Index for the six months before and six months after historical ECB rate cuts starting: May 11, 2001, November 12, 2008 and November 9, 2011 
As of December 31, 2023
Source: Morningstar and AB (AllianceBernstein)

We believe that investors should aim to get ahead of the ECB’s first rate-cut decision. That means making the switch now. 

Cash Yields Look Set to Dwindle

Meanwhile, investors who stay sitting in money market funds will likely see their yields decline progressively, resulting in a lower annualized return than they may have expected, given starting cash yields. While the exact path of cash deposit rates is hard to predict, the likely trajectory is clear—down (Display).

Falling Rates Mean Lower Cash Income
ECB Rates Implied by Market Pricing
Markets are expecting the first ECB rate cut in April with 150 basis points of cuts in total by the end of 2024.

Current analysis does not guarantee future results.
As of  February 5, 2024  
Source: Bloomberg

Although money market funds may currently offer attractive starting yields, their underlying investments are short-term, and with each cut in rates the maturity proceeds of those securities must be reinvested at lower yields. By switching to longer-term fixed-income investments, investors can delay that reinvestment risk in line with their choice of bond maturities.

Yields May Surprise, but Asymmetry Favors Bondholders

In a troubled world, it’s important to consider the downside. Geopolitics remain worrisome, and global conflicts could trigger an inflation shock to change the rates outlook. Services inflation and related private sector wage rises have been sticky and could continue to trouble policymakers, putting upward pressure on rates. Even so, we believe the potential downside risks to bond prices are well compensated by current high bond yields. 

In our analysis, today’s yields provide a big enough cushion to mostly offset the impact of a possible 1% rate rise, while providing high single-digit gains in the event of a likely 1% rate cut (Display). Although risks remain, this asymmetry of outcomes favors bondholders.

Current High Starting Yields Help Cushion the Impact of Potential Rate Rises
Simplified Scenario Analysis: 12-Month Potential Return (Percent)
Across the Euro Aggregate, Investment-Grade Corporate and High-Yield Indices, the balance of risks favors bondholders.

Current analysis does not guarantee future results.
Simplified analysis assumes current starting yields and durations of indices, a parallel yield curve move and no change in credit spreads.
Indices used: Bloomberg Pan-European High Yield, Bloomberg Euro Aggregate Corporate, Bloomberg Euro Aggregate Total Return
As of January 31, 2024
Source: Bloomberg, Barclays and AB

Time Is of the Essence

Euro fixed income currently offers yields that are very high relative to recent history and have scope to fall to much lower levels and generate attractive gains. Meanwhile, struggling euro-area economies cannot tolerate current high interest rates indefinitely. Ultimately, the question is not whether to move out of cash, but when.

Investors can expect continued volatility as yields trend lower over the next few months. However, given a likely surge in demand for bonds and expected erosion of cash yields, investors who act now can position themselves for strong potential returns. That’s why, while cash has ruled in the past, there’s no time like the present to switch to fixed income. 

The author would like  to thank Vishali Thakker, Fixed Income Product Manager, for her invaluable contribution to this research.

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.

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