Higher frequency data, such as the purchasing managers’ indices for manufacturing, suggest that output has continued to expand, both consumer and economic sentiment are on the rise, and although it is a lagging indicator, the unemployment rate has stabilised at 12.0 per cent.
This improvement has led interest rates, particularly in the periphery, notably lower, with 10-year sovereign bond yields for Italy, Spain and Ireland having fallen to pre-crisis levels. This decline in interest rates is not only significant for the European economy, as lower rates in the periphery suggest that markets believe the recovery is real, but also for each country’s finances, as lower interest rates mean that the cost of borrowing is more affordable.
As mentioned above, the rally in peripheral bond yields has been driven by a combination of declining perceptions of risk and improving economic fundamentals. These risks first began to subside in the wake of European Central Bank governor Mario Draghi’s “bumblebee” speech in 2012, where he declared that the ECB would do whatever it took to save the euro. This pledge, coupled with easy monetary policy and a commitment to keep interest rates low for the foreseeable future, has helped push yields lower.
Additionally, and perhaps more importantly, the perception of country-specific risks has been reduced as governments have introduced much-needed structural reforms to create a more stable and less divergent economic and political environment. This explicit commitment to reform, coupled with improving fundamentals, has helped bring the eurozone out of the worst recession in the history of the common currency. Italy is a prime example of the strong reversal of investor risk aversion, as recent political developments have been considered an opportunity, rather than a headwind. In other words, markets have viewed political changes in Italy as an opportunity to accelerate the process of reform, rather than a precursor to a period of instability.
The perception of country specific risks has been reduced as governments have introduced much needed structural reformHowever, it is important to keep in mind that interest rates have three components: the risk-free rate, a credit premium, and an inflation premium; in other words, the yield on a bond is defined by the base rate, how risky the investment is, and expected inflation. Expected inflation in the eurozone over the next 10 years currently sits at 1.6 per cent, 0.4 percentage points below the ECB’s inflation target and well below average inflation expectations over the past 10 years.
Thus, while the decline we have observed in interest rates is partially due to stronger economic growth and a historically low ECB policy rate (that is, a lower risk-free rate and dwindling credit risk), it may also be a function of a more subdued outlook for inflation. That being said, this low interest rate environment presents an excellent opportunity for countries to refinance their debt at lower borrowing costs, allowing them to reallocate resources to reduce taxes, re-launch competitiveness, and encourage employment and consumption. However, this approach is not without risks. The first risk is that markets expect further market intervention by the ECB, but fail to appreciate that at the current juncture, the central bank’s tools are quite limited. The second risk is that governments could feel less pressure to implement the necessary fiscal and structural reforms given the favourable, low interest rate environment.
Looking ahead, there is seemingly still value in periphery bond markets. Economic fundamentals in the periphery are expected to continue to improve gradually, which should be supportive of lower bond yields going forward. Additionally, political risks have subsided, and the rating agencies have begun raising their outlooks for some peripheral countries after a series of back-to-back downgrades. Given that interest rates will eventually start to rise, investors should work to build more flexible bond portfolios, focusing less on traditional sources of income and more on where there is still value. Furthermore, looking at Spanish and Italian government bonds could provide investors with a source of income which, coupled with some exposure to credit, may help to reduce the impact of rising interest rates on their portfolios.
Kerry Craig is global market strategist at JP Morgan Asset Management
