Light at end of euro tunnel?
Has the European Central Bank done enough to convince investors that it is ahead of the curve and in charge? Not according to some managers, like Helena Morrissey, head of fixed income at Newton Investment Management, who suggests that the quarter-point rate hike in March did little to bolster investor confidence in the bank. She goes on, “Policy-making in Europe is clearly not one step ahead of the game, and all their mealy-mouthed statements do not inspire confidence.”
Morrissey acknowledges that actual rate hikes have improved perceptions over recent months, although she describes European markets as being in an “unstable equilibrium” just now. “European bonds are certainly our least favourite market for the moment. We would much rather own US Treasuries, which should yield less than Bunds by our reckoning – although, to date, this year has been more about avoiding weakness rather than backing strength.”
Alliance Capital’s Doug Peebles broadly agrees, although he is somewhat more sympathetic, given the learning curve the ECB members had to climb last year. He points out that the ECB’s actions deserved a lot more praise than the seemingly disparate comments uttered by various ECB board members over the year. He believes that their credibility is on the increase now, if only because the European economies are more in synch, with even the laggards of Germany and Italy showing strength, which means that the ECB board members’ various domestic biases are in more harmony.
The ECB does have its fans already. Eric Brard at Indocam thinks that its credibility is not in question, saying that the ECB’s job is to maintain price stability – which it has so far done successfully. Brard is reasonably comfortable with European bonds and explains: “If you do not believe that 10-year Bunds will reach 6%, or if you think the market will range trade, then it is too expensive to be short, because the cost of carry is too high. Looking at the structure of flows, it seems clear to us that many investors are liquid and probably underweight, which supports our view that we will be range trading for a while yet. Ten-year Bunds at around 5.3% represent OK value, but we are not overly bullish. The key risk to our benign scenario would be a continued acceleration of global economic growth which, together with the oil price rises, could cause inflation fears to re-emerge. However, we are fairly sure that US monetary policy will have the right impact and that economic growth will be slowed to a more reasonable rate.”
Peebles, who heads Alliance’s global/international fixed income department and is lead manager of its European Income Opportunities Fund, is less positive about the market in general and believes that yields look set to rise across the curve. “It is not a great scenario just now, but on balance we would argue that the longer end is safer, because the yield curve should continue to flatten over the coming weeks.” Morrissey agrees, saying that European yield curves are still the most positive in the world and, even though some flattening has already occurred, the flattening trend is still intact.
As for the currency, there seems to be another consensus building, namely that the euro ought not to fall much further. However, some managers are still unconvinced that its fortunes will improve dramatically. Morrissey, for one, is not ready to announce a bullish view, saying: “We have been rather dismayed by the immunity of the euro to react to positive news, but think there may be chinks of light at the end of the tunnel. Many investors have cut their long euro positions and we may be seeing the ‘throwing in of the towel’ by investors who are finally giving up.
That the yen failed to break through the 100 level against the euro is also positive for the euro. The currency’s weakness is not about European economic growth rates or interest rate differentials with the US, it is about credibility and perception.”
“The euro is fundamentally cheap,” says Peebles. “Few could disagree with that statement. But fundamentals do not count yet. The downward pressure is coming from both sides. Firstly, we would argue that foreign investors are still long and have more selling to do and, secondly, domestic flows are net outward as FDI flows out of Europe. The US, and especially Silicon Valley, is still seen as a good place to be for healthy returns on investment. As we get more structural reform in Europe then the latter situation will become less extreme over time, of course but for now it is a heavy drag on the euro’s performance.”
Morrissey agrees that the soaring NASDAQ has indeed been positive for the dollar, but thinks that the increasing volatility in that market may be a sign that confidence in all things American may be on the wane.
She is still reluctant to back the euro, even if there were to be a major crack in the NASDAQ. “If the US market has a big fall, then it has to be negative for the dollar, but it would probably be the Japanese currency which benefited more. The euro is our ‘rock and a hard place’ currency at the moment and is not about to become the star currency, just yet.”