Increasing variations in interest rates on government bonds the Eurozone have reawakened fears of bankruptcy in the periphery of the eurozone. The ECB says it will do everything it can to contain this threat of fragmentation. It remains uncertain though whether financial markets will continue to swallow the ECB›s narrative. These are painful times for bond investors, but there are opportunities.
“The entire Anglo-Saxon community is obsessed by the spreads,” said Dutch central bank president and ECB governing council member Klaas Knot last Friday on Dutch BNR Nieuwsradio. A justified comment, because the spreads show whether financial markets still have faith in the ECB›s monetary toolkit.
Later this year, details will emerge of a new «anti-fragmentation» tool with which the ECB hopes to close the interest rate gap that has emerged on European government bonds. Italian long-term government bond (BTP) yields have risen from less than 1 per cent at the start of the year to more than 4 per cent in recent days. At the time of writing, the yield on 10-year Italian government bonds has fallen slightly again to 3.67 per cent.
Debt and spreads
The prospect of the ECB raising interest rates has once again raised fears about the flaws in the design of monetary union. With budgets still largely a sovereign matter and the European banking union incomplete, weaker countries such as Italy could come under great pressure in periods of financial turbulence.
Peripheral Member States have become accustomed to low interest rates. Their debt as a percentage of GDP has continued to rise in recent years while interest rates have fallen continuously.
ING senior economist Bert Colijn sees that markets are still confident about the effectiveness of the instruments to be announced and is currently giving the ECB the benefit of the doubt.
“We see that spreads are coming back somewhat from their highs earlier this month. So the market seems to have faith in the ECB›s ability to act. The only question is whether markets will continue to do so when the ECB reveals the details of the instrument,” Colijn said.
Ralph Wessels, head of investment strategy at ABN Amro, said it was likely that the ECB›s decisiveness would be tested by market participants with exposure to Italian government paper. “Large players can force the ECB to take real action by letting the spread widen. Mind you, bond markets are very large markets so you have to be a serious party or have many, but we often see Central Bank policies being tested.”
Italian government bonds are interesting right now
However, it is a misconception that a country like Italy would no longer be able to pay its debts if interest rates rise, said Wessels. “The average length of Italian debt has been made longer and the debts have been refinanced at cheaper rates. They will not run into acute problems if interest rates rise very fast now. That does not alter the fact that it will hurt if the high interest rates continue for a longer period.”
Wessels acknowledged that ABN Amro slightly underestimated the increasing spreads. Nevertheless, he is still positive on bonds from the periphery, including Italian government bonds, but is not buying into them yet. “We do not think that the current levels invite buying, but that has more to do with the rising interest rates than the spreads. Bond investing is always painful when interest rates rise, also now.”
Yet he does not foresee a bleak future for government bonds in the medium term. In the coming 18 months to two years, many opportunities could arise for government bond investors, Wessels believes.
“We see interest rates rising to curb inflation. With the very large assumption that inflation will fall, bonds will again have a protective role in the traditional investment portfolio. The risk, however, is that there is a chance of sustained inflation. However, research shows that inflation expectations are strongly correlated with commodity price movements. That makes it extremely difficult to make predictions about it.”
Investors should listen to the ECB
Hendrik Tuch, head of fixed income at Aegon Asset Management, said investors should listen very carefully to the ECB, no matter how “stupid and illegal the ECB intervention” might be.
According to Tuch, investors cannot stay underweight in government bonds forever. “It could well be that the ECB will apply the 4 percent interest rate on Italian government bonds as a maximum for a longer period. In that case, investors can ‘sit on the carry’ relatively safely, i.e. profit from the spread on these bonds in the expectation that they will not change during a summer where volatility is low.”
Risk of ‹doom loop› risks resurfacing
Nouriel Roubini, chief economist at Atlas Capital Team, wrote in his column in the Financial Times earlier this week that the widening spreads are problematic for the eurozone, but that is not the only problem.
The recent rise in Italian interest rates and other spreads is not just the result of irrational panic among investors, Roubini argued.
“Italy has low potential growth, large budget deficits and huge, potentially unsustainable public debt that has increased during the pandemic.”
Weak potential growth and job creation combined with a ‹hard landing› by the ECB will reignite market concerns about debt sustainability in peripheral countries, according to Roubini.
“With the ECB withdrawing its ultra-accommodative policy, the cost of debt risks rising permanently. The risk of a ‘doom loop’ is greater in Italy than in the rest of the eurozone. This ‘doom loop’ between governments with debt and banks holding that debt, a feature that was burnt into the memory of many a decade ago by the debt crisis, will come back into focus,” Roubini said.
This article originally appeared on InvestmentOfficer.nl.