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Fixed-Income Insights

The European Central Bank’s “lower for longer” policy stance on interest rates may be creating attractive conditions for certain U.S. fixed-income investments.

 

In Brief

  • The European Central Bank (ECB) looks likely to continue its “lower for longer” interest-rate policy and aggressive program of bond purchases.
  • Why? Given a lack of fiscal stimulus from member nations, expectations for a weaker eurozone economy in 2017, and protectionist trends, the ECB may have difficulty meeting its inflation target of 2%.
  • In contrast, U.S. fixed-income securities continue to feature relatively attractive rates, and are likely to continue to attract global investment flows.
  • The key takeaway—Global investors facing unattractive debt-investment options, courtesy of global easy monetary policy, will continue to find U.S. options attractive, particularly corporate debt.

 

The European Central Bank’s (ECB) policy announcement after its October 20, 2016, meeting confirmed the continuation of its current negative interest-rate policy and its aggressive quantitative easing (QE) program.  “Lower for longer” is still the ECB’s monetary policy mantra. The ECB’s low-rate regime, along with similar policy approaches at the Bank of Japan and the Bank of England, keeps rates on debt of those developed nations low, or even negative.  It also helps keep a lid on U.S. interest rates.  Global investors who are facing unattractive debt investment options, courtesy of global easy monetary policy, will continue to find U.S. options attractive, particularly corporate debt.  Further, it does not look like this situation will change anytime soon.

If things were different, however, the ECB could have tapered its €80 billion per-month QE program, considering the fact that the bank may indeed be “running out of bonds to purchase” (a similar quandary is faced by the Bank of Japan). Monthly net issuance of all long-term eurozone sovereign debt has averaged €16.7 billion since the beginning of 2014 through August 2016, according to the ECB.  Nonfinancial corporate net issuance has averaged €3.85 billion per month during that time. 

It is not surprising, then, that €80 billion per month in new purchases faced with an average of only €20.55 billion (€16.78 billion sovereign debt plus €3.85 billion corporate debt) in new supply has led to higher prices and lower yields on most eurozone debt.  Even if the ECB were to “taper” its purchases to €60.0 billion, the supply/demand imbalance would be reduced, but would be far from eliminated.  Yields on eurozone debt do not appear soon to be headed substantially higher.

Aggressive Policy
Given the ECB’s inflation goal of 2% and its most recent inflation rate, 0.4% for September, the bank may have no option other than maintaining its current aggressive stance.  While there is some discussion of tax relief in Germany, there is no meaningful fiscal stimulus to help monetary policy achieve its inflation goal. 

Increased protectionism could provide yet another obstacle in the ECB’s path toward 2% inflation.  Recent setbacks for the Comprehensive Economic and Trade Agreement (CETA), the European Union’s (EU) trade agreement with Canada, and the Transatlantic Trade and Investment Partnership (TTIP), the EU’s trade deal with the United States, suggest impediments to growth and related inflation. Upcoming EU discussions with the United Kingdom on the terms of “Brexit” (when the United Kingdom decided to leave the EU) reinforce expectations of slower trade, slow growth, and deflationary trends. 

According to its most recent projections in September 2016, for example, the ECB expects to reach its goal of close to 2% inflation by the end of 2018.  Given the lack of fiscal stimulus, expectations for a weaker eurozone economy in 2017, and the current trend toward protectionism, it seems that new projections at the ECB’s December policy meeting will push out achievement of the inflation goal to 2019.  An alternative forecast for higher inflation sooner may be possible if significant currency devaluation increases import costs and boosts domestic inflation.  However, such a scenario could easily create a slow-growth, inflationary environment (i.e., “stagflation”), given the absence of fiscal stimulus and the trade benefits lost to failed CETA and TTIP negotiations, and the potential for difficult “Brexit” talks. 

Clearly, the advent of stagflation would not encourage rising rates.  “Lower for longer” may be ECB president Mario Draghi’s primary strategy to “do what it takes” for the next few years to make even slow progress toward the ECB goal of 2% inflation.

Coming to America
The economic and political environment in Europe suggests a negative interest-rate policy and aggressive QE bond purchases will prevail, keeping eurozone rates low, if not negative.  In comparison, relatively attractive rates on U.S. fixed income will continue to attract global investment flows.  Flows from Europe and other lower-yielding countries, such as Japan and the United Kingdom, should support U.S. fixed-income prices as well as the U.S. dollar. 

Currency movements also will play a role. As the U.S. Federal Reserve (Fed) pursues higher short rates, the U.S. dollar may be further supported, potentially at the expense of emerging-market currencies and debt as global short-term monies take advantage of higher short-term U.S. interest rates.

While we expect support from global investors, rates on five- to 10-year U.S. Treasury bonds, at about 1.25% and 1.75%, respectively, based on Bloomberg data, are unlikely to decline further as a result of European investor interest.  Why? After considering the cost of currency hedges, U.S. Treasuries offer yields close to those available in Europe.  In other words, despite respective five- and 10-year yields in Germany of -0.5% and +0.02%, after hedging back to euros, U.S. Treasuries offer little economic advantage. 

Higher-Yielding Choices
European investors, however, may instead find U.S. corporate credits and high-yield issues much more attractive.  Even after hedging costs, such higher-yielding U.S. investments are likely to offer economic advantage to non-U.S. investors.  Thus, in an environment of “lower for longer” monetary policy, combined with relatively respectable U.S. economic growth of about 2.0%, high-yielding, economically sensitive U.S. corporate debt could find support from non-U.S. investors.  This helps explain the compression of yield spreads of U.S. high-yield debt relative to U.S. Treasuries of comparable maturity. 

Continuation of current ECB policies, combined with a Fed that persists in its slow pursuit of higher short-term rates, suggests that flatter U.S. yield curves could continue to unfold, especially among high-yield securities.  The economic strength that allows the Fed to pursue its objectives provides further support to economically sensitive debt, both loans as well as traditional high-yield securities.  U.S. economic growth, combined with low rates in Europe and elsewhere, creates, in our view, an attractive investment environment for higher-yielding fixed-income securities in the United States.

 

ABOUT THE AUTHOR

RELATED FUND
The Lord Abbett Floating Rate mutual fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.
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The Lord Abbett High Yield Fund has offered a track record of strong performance versus peers in up and down markets. Learn more.

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