“The next recession could be very painful and potentially existential for the Eurozone…”

by | May 9, 2018

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Today’s Europe Day marks the anniversary of the Schuman declaration which paved the way for the creation of the European Union, Jon Day, Fixed Income Portfolio Manager at Newton IM, shares his views and outlook for the region:

“In a bond world where the Federal Reserve is firmly on a path of rate rises and balance sheet reduction, Eurozone bonds are starting to become something of a safe haven.

“Inflation remains stubbornly low within the Eurozone.  Core inflation continues to hover around 1% well below the ECB’s “at or near 2%” target.  Slack in the system remains high with the unemployment rate still at 8.5%.

 
 

“The ECB remain confident that they are on track to reduce their quantitative easing programme, perhaps to zero later in the year, however, there are some signs they are starting to waver with recent economic indicators showing a slowdown in the Eurozone recovery.

“Although Bund yields (ten year) are around 0.6%, on a currency hedged basis they are not as bad value as first appears, a ten year Treasury hedged into euros would only yield 0.1%.  This is due to the large interest rate divergence between the Federal Reserve and the ECB crushing any extra yield on the Treasury.

“Even if the ECB decides to halt its bond buying programme, the central bank has committed to reinvest any maturing bonds.  This will continue to be a powerful support for Eurozone bond markets as government deficits are low so the amount of ‘new’ money that Eurozone governments need is low, very different to the sizeable increase in borrowing planned by the US.

 
 

“Short term the biggest risk to this scenario is a sudden increase in inflation, which will push the ECB to accelerate the withdrawal of stimulus, this would push all Eurozone yields higher but could become very painful for Italy.  Given the ongoing Italian economic and political stresses, ECB support has significantly suppressed their bond yields.  Italy’s government debt levels are high and any increase in yields would put pressure on its ability to service its debt.

“Longer term dissatisfaction amongst the Eurozone’s population has not gone away, populist parties are still doing well in elections, the recent cyclical economic upswing has masked some of these issues, but unemployment remains high (especially youth unemployment).  The next recession could be very painful and potentially existential for the Eurozone given the ECB’s toolkit has already been almost fully used and governments have limited ability to increase fiscal stimulus.”

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