It seems like only yesterday that markets were expecting quantitative tightening (QT) and higher volatility. But now, renewed euro-area quantitative easing (QE) will likely suppress volatility—and bail out the sovereigns that have been struggling the most.
Around the world, long-term government bond yields have been falling. That’s because many investors have downgraded their domestic and global growth forecasts, and the market has priced in a high probability that both the US Federal Reserve (Fed) and European Central Bank (ECB) will cut interest rates before the end of the current year.
Big Turnaround in Policy Direction
This is quite a turnaround from where we were just a few quarters ago. Back in November, the market was still anticipating that the Fed would gradually raise interest rates throughout all of 2019 and 2020. Similarly, in Europe, the ECB was expected to tighten policy, and European investors were speculating how much German Bund yields would rise, and Italian sovereign spreads would widen, without the support of QE.
Fast forward to today, the market now expects the Fed to cut interest rates by 1% over the coming 12 months. Following retiring ECB president Mario Draghi’s recent comments at Sintra, it also appears to be a question of when—and not if—the ECB will cut the deposit rate further and restart the QE programme. New ECB president Christine Lagarde is widely perceived as a dovish successor and has an eight-year term in front of her.
Government Bonds: Euro-Area Spreads to Narrow
How will this impact bond markets in future? If economic growth remains on track and base case forecasts are realized in the coming quarters, government bond yields are unlikely to move significantly lower from current levels. But the risks to growth are still heavily skewed to the downside. World economies face the direct impact of trade tariffs, the second-round effect of falling business confidence and the negative impact of leverage through a highly borrowed corporate sector. So considering this array of risks, high quality government bond yields are unlikely to move higher. In an overall portfolio context, government bonds are also likely to provide a nice offset to risk assets should any of the downside scenarios materialize.
Within the euro area, Italy is likely to be the main beneficiary if the ECB restarts QE. Given that it trades with yields close to those of Greece (B-rated) and well above Portugal, there is plenty of room for Italian sovereign spreads to narrow. Italian government securities’ (BTPs’) wide spread to Bunds has resulted from multiple negatives. These include a potential imminent credit-rating downgrade to high yield (and subsequent removal from broad bond benchmarks), weak domestic economic growth, a budget deficit battle with the EU and a buyers’ strike following the end of QE purchases. The Italian government has already started to address these issues, with this year’s forecast budget deficit now reduced from 3% to close to 2%. But a new round of QE would help allay all these problems for bond investors. Irrespective of underlying economic and political issues, the support of the ECB bid would keep BTP spreads down and volatility in check. And while the BTP market has already reacted favourably to the recent news, there is further to go, in our view.
The spread on 30-year Italian bonds still trades close to 275 bps wide to German Bunds. But the Italian yield curve remains very steep, with yields on short-term bonds now more than 200 basis points below the elevated levels of 2018. We expect Italian bond spreads to tighten further in the coming months, with longer-dated bonds likely to be the stronger performers.
