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Fixed-Income Insights

The European Central Bank’s planned purchases of euro-area government debt far exceed available supply. The impact on fixed-income markets could be dramatic—and extend far beyond the Continent.

 

In Brief

  • The European Central Bank’s quantitative easing plan calls for the purchase of €60 billion per month in debt, including €47 billion in government securities.
  • However, the ECB’s allotment for the purchase of government bonds likely will far exceed the net new supply of such securities expected in the Euro area in 2015 and 2016.
  • How could this imbalance affect fixed-income markets? Already low yields on European corporate bonds could fall further, spurring greater interest in U.S. government and corporate debt. 
  • This, in turn, could put additional pressure on the euro and push the U.S. dollar higher. Investment flows to the United States could be enhanced by currency return.
  • The key takeaway— While the U.S. Federal Reserve may raise short-term rates in 2015 and 2016, the ECB’s program will provide a headwind, if not an offset, to similar rate movements on longer-maturity and lower-quality fixed-income securities.

 

How can we quantify the impact of quantitative easing (QE)? In the case of the European Central Bank’s (ECB) QE effort, launched in March 2015, the bond-purchase program appears positioned to affect the European fixed-income market to a greater degree than the U.S. Federal Reserve’s (Fed) QE programs influenced U.S. interest rates.

The ECB’s planned purchases total €60 billion per month (through September 2016). Of that amount, the central bank intends to buy €47 billion in government securities—a figure that will dwarf the monthly net new supply of government debt expected in the eurozone in 2015 and 2016. As a result, the ECB will be forced to pry securities from current owners with higher prices—and in the process, push yields lower, in some cases to negative levels. Expect this pressure on European government yields to have a spillover effect on corporate yields in Europe and, ultimately, on fixed-income markets in the United States as well.

To that point, about 25% of the securities in the Bloomberg Eurozone Sovereign Bond Index already trade at a negative yield. Even some corporate bond issues recently traded at negative yields, including bonds issued by BP, Novartis, Royal Dutch Shell, and Nestlé. And the QE program has just begun.

An Aggressive Program
Here’s how the ECB’s version of QE will work: The ECB will purchase about €13 billion per month under its asset-backed securities purchase program and the third phase of its covered bond purchase program, both of which began late last year. This leaves €47 billion of the €60 billion program directed toward euro-area government securities.

However, the central bank may not be able to spend all that money. The ECB reports that net issuance of euro-denominated government securities in the euro area in 2014 totaled €207 billion, an average of a little more than €17 billion per month. The ECB’s monthly QE appetite of €47 billion is 276% of that financing requirement. That percentage may increase, as both Standard & Poor’s and Deutsche Bank have forecast that euro-area sovereign borrowing will be even lower in 2015. 

This compares with the Fed’s QE programs that funded 61% and 71% of U.S. Treasury borrowing in 2011 and 2013, respectively. At the time, commentators described the Fed’s programs as “stunning” and “unsustainable.” But the Fed’s efforts look like small change by comparison. With so much ECB money chasing so little in available government debt, it is not surprising that anticipation of the QE program has pushed many of the euro-area government securities to a negative yield as of early April 2015.

Euro-area Consequences
What other consequences should we anticipate as a substantial, price-insensitive buyer (the ECB) continues to execute the remaining 95% of its planned purchases? For one, shortages of euro-area government debt seem likely. These may be overcome by higher prices necessary to force the sale of securities held by pension funds, insurance companies, and other investors. Because the ECB has limited its purchases to those that would produce a yield no lower than -0.20%, but is willing to purchase securities with maturities of up to 30 years, investors should expect negative yields to creep out to longer maturities. As a result, euro-government yield curves should flatten.

As investors are persuaded by the ECB to part with their euro-area government bonds, low or negative yields on European corporate bonds (a phenomenon we have already observed) will likely have substantially less appeal than other global options, including U.S. government and corporate debt.  Generali Investments Europe reported in February 2015 that more than 30% of euro-area government debt is held by foreigners and that more than 20% is owned by pension funds and insurance companies, suggesting large numbers of investors with an ability to invest outside Europe.1 Thus, continued pressure on the euro currency would not be surprising as investors sell their euro-area debt to the ECB, and then exchange the euro proceeds for the currency of more attractive investments that may be available in the United States or elsewhere. A weaker euro and increased interest in higher-yielding non-euro-area debt are two more potential consequences of the ECB’s program.

Spillover Effect
Just as the Federal Reserve’s QE programs pulled yields lower, compressed yield spreads, and increased demand for risky assets,2 the ECB’s effort throughout 2015 and 2016 may be expected to produce similar results. In fact, with yields on European debt already substantially lower than comparable U.S. securities, and with the demand/supply imbalance created by the ECB’s relatively large purchases compared to expected net new supply, the spillover effects to the United States and other markets could be significant. If investor reallocation from euro-area securities to the United States puts additional pressure on the euro and pushes the U.S. dollar higher, investment flows to the United States could be enhanced by currency return. This process could be self-reinforcing, at least for a while.

It is hard to predict how many investors will seek non-euro alternatives, and where these investment flows will have the most impact. For those seeking alternatives in the United States, with the Fed intent on raising rates in 2015 and 2016, investors may opt to avoid the longer-term interest-rate risk of high-quality securities and focus instead on shorter-term U.S. bonds, or on issues that are more aligned with economic risk. Such options would include high-yield securities and possibly the lower-quality tiers of investment-grade corporate securities. 

Such demand may coincide with a reduction in the supply of available U.S. corporate debt that is also a function of developments in Europe. Lower rates in Europe have attracted U.S. corporations to raise inexpensive funds at a remarkable pace in recent months. According to Thomson Reuters, U.S. companies issued nearly €19 billion of euro-denominated debt in the first two months of 2015, 160% of the previous year’s pace. Companies such as Coca-Cola, Kellogg’s, AT&T, and Berkshire Hathaway have taken advantage of lower rates in Europe. To the extent those borrowings would have otherwise take place in the U.S. market, and to the extent the proceeds are used to refinance existing U.S. debt, the supply of U.S. corporate debt securities would be reduced, potentially providing further support to prices of U.S. corporate debt.

A Bigger Impact?
Just as the Fed’s QE programs extended their impact beyond the securities that were purchased to other investments, markets, and currencies, the ECB’s program seems positioned to have similar spillover effects.  In fact, the size of the ECB program, applied to a European fixed-income market that is smaller and potentially less liquid than the U.S. market, suggests that the impact on rates may be greater than what we witnessed with the Fed. After one month, the consequences of ECB QE are already unfolding. Negative yields are widespread among European government bonds. 

As we noted before, low yields on European corporate bonds have attracted debt issuance by non-European companies, particularly those from the United States. The euro has declined 10% relative to the dollar since the beginning of the year. While other market movements cannot be exclusively attributed to anticipation of the ECB’s program, it is worth noting that yield spreads on lower-quality U.S. corporate bonds have compressed and Treasury yields have moved lower. Despite the Fed’s intention to move rates higher, the yield on the two-year U.S. Treasury note fell, from 0.67% to 0.55%, during the first quarter of 2015, while the 10-year Treasury yield fell, from 2.17% to 1.90%, over the same period.

The cumulative effect of the ECB’s program over the next 20 months or so is impossible to forecast, but the consequences of lower interest rates in the euro area—and the likely downward pressure on rates in the United States and potentially elsewhere—is hard to argue against. The Fed may raise short-term rates in 2015 and 2016, but the ECB’s program will provide a headwind, if not an offset, to similar rate movements on longer maturities and lower-quality credits.

 

1”GIE Research Market Commentary,” Generali Investments Europe, February 2015.
2Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack, "The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases," International Journal of Central Banking (March 2011).

 

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