The era of negative interest rates on government bonds is over, but the moment when government bonds will again generate both portfolio protection and returns is still far away. Especially in Europe, the situation is tough. The ECB has its hands tied. The need to save Italy means Eurozone interest rates can only rise so much. “Make no mistake about it: the next six months won’t be pretty.”
Ella Hoxha (photo), government bond specialist and senior investment manager at Pictet Asset Management, cannot imagine that interest rates in the eurozone will eventually rise above two percent. She believes eurozone interest rates are facing a ceiling as the European Central Bank has its hands tied behind its back, especially in Italy’s bond market.
“The neutral rate in Europe - it depends which projection analysis you use - is somewhere in the region of about half a percent to a percent. Because you have this exceptional circumstance of an energy crisis, when a central bank takes rates to two percent, you’re already going double your neutral rate or more. So that kills the economy over the long term. That’s why we’re saying that’s really your ceiling,” Hoxha explained in an interview with InvestmentOfficer.nl.
German government bond yields rose to their highest level in decades in August. While higher interest rates are attractive, they pull government bond prices down sharply. Bond investors today eagerly await the ECB›s first monetary policy meeting since July, when the key interest rate was raised for the first time since 2011. The ECB›s interest rate path is all-important.
Can the ECB control inflation?
“They will be hiking but can they control inflation?” Hoxha asks, referring to the ECB. “It’s very difficult, but they can’t afford not to. Not fighting inflation has much bigger social repercussions; you will see people on strike. High inflation oftentimes causes riots and political instability. Make no mistake about it: the next six months won’t be pretty.”
Hoxha’s team at Pictet does not consider European government bonds as an attractive investment. “The euro is weak, inflation is high, and the ECB is stuck.”
“Europe has an energy problem, it has an inflation problem, and it has a central bank that wants us to believe they’re hawkish, but it’s constrained. Why? Because if it pushes rates too high, it punishes the periphery. Italy and other countries that cannot afford to have much higher interest rates would get into trouble soon. So what does this all mean, for us in Europe? It probably means that the ECB is likely to hike by less than the market expects,” said Hoxha.
In Hoxha’s view, German ECB board member Isabel Schnabel is a key indicator of sentiment within the ECB board. The market listens carefully to what she has to say.
At Jackson Hole, Schnabel “put forward the case of why we need to do more, i.e. more tightening of monetary policy. To accompany that we also had these record inflation prints last week in Europe. What’s happening now is that the central bank is realizing that if we have to tighten, we have to do it now.”
Italy is too big to fail
Hoxha believes that Italy is a key topic in the debate at the ECB. Italian voters will go to the polls in less than three weeks, on Sunday 25 September. “It is the most indebted country in Europe, and it’s also too big to fail. It is the third largest economy. So if you disrupt Italy, you have a massive problem.”
To keep the country stable you need a well-functioning bond market and you can’t just, given their massive debt level, raise interest rates, Hoxha said.
The ECB’s new anti-fragmentation programme, known as TPI, announced in July, is a “lifeline for Italy”, she said. “Investors are testing the system by dumping Italian bonds so that the supply-and-demand principle pushes up interest rates. The ECB will have to intervene, but that reduces the incentive for politicians to adjust fiscal policy.”
Post-election blow-up could provide opportunities
The context may however present new opportunities for investors.
“At some point, Italy might become interesting because investors will be compensated for some risk,” she said. “But the implementation of the TPI means that any major widening (of spreads) will be pushed back by the ECB.”
“Any sort of blow up on the back of the elections and the talk that might come out of Italy might present a good opportunity for investors to buy. Somewhere in the region of 250 to 400 basis points above Germany is attractive for Italy,” she said, referring to the 10-year Bund-BTP spread which stood at 230 basis points on 7 September.
4% as absolute level
Hoxha said Pictet sees the level of 4 percent for as the 10-year yield on Italy’s BTP’s as “the absolute level”. She said that the TPI programme makes “a blowout of the spread less likely” which has led Pictet to close some of its short positions.
“One thing that investors have learned is to not fight the central banks too much. If the ECB wants to save the Italian bond market it will save the Italy bond market,” she said.
Hoxha considers German government bonds attractive at 2 percent. The US is also attractive. “There you get 3.5 percent in a market where the dollar is also very appreciating. We are at the beginning and the end of the curve in the US, so 2-year and 30-year government bonds. We also find China, Mexico and Brazil interesting.”
Bearish case priced in in Europe
On the weak euro, Hoxha said she believes «the bearish case in Europe” is already in the price. The euro, which is trading below the dollar at the time of writing, is at its lowest point in 20 years. “The propensity for a move in the other direction is very high. So this is how we tend to think. We think about contrarian positioning indicators and then we think about what’s fully priced or not priced at all.”
“I’m going to close my euro shorts. That’s step number one. So at least we’ve neutralised that in our clients portfolio. And we’re now looking for opportunities to actually own it, so go the other way, which is probably a dirty word now in financial markets, because no one wants to buy it.”
This interview originally appeared in Dutch on InvestmentOfficer.nl.