European markets naturally reacted well to the bold move by the European Central Bank (ECB) to cut rates in early April. The continuing signs of a slowdown in Europe led the ECB to make a larger than expected cut in interest rates to 2.5%. In the foreign exchange markets, the euro has not had a comfortable ride, continuing to fall against the US dollar, in part in reaction to the worsening conflict in Kosovo. But it has to be pointed out that the euro has been weakening steadily since its inception, and there are signs that the ECB is already having to intervene to support the currency. Contrast this with the stability of sterling and the yen and the appreciation of commodity-related currencies like the Australian and Canadian dollars.
Marc Polydor, chief investment officer at Union Banque Privée in Geneva, suggests that although the ECB has said it will be the last interest rate cut for the foreseeable future, we cannot discount the fact that it may be forced to change its stance.
“The ECB has shown that it is still quite flexible, and despite the inflation outlook, observers are pointing out that the monetary aggregates have been moving very fast.”
A 50-basis point move shows, he says, that it is acting like the Federal Reserve, which is in keeping with the plan included in the Maastricht treaty. The driver of convergence is in place, with bond yields stable and the culture of low inflation reinforced. Inflation expectations are low and we have a relatively stable bond market. Polydor says: “The aim should be stability, but the ECB will also be working to implement policies which are pro-growth. That is what the Federal Reserve does and what the ECB seems intent to do.”
The ECB will continue to monitor the strength of the US dollar. Euroland’s short-term economic outlook is weak, but a global recovery, strong US growth and a weaker euro could spark growth.
Schroders’ bond managers remain confident of the backdrop for bonds, despite their vulnerability in the short term, especially as yields have fallen to near historical lows. Their reasoning is that the reduction in bond yields (which resulted from falling interest rates) that drove bond prices higher, has largely run its course. In addition, there are some investor concerns that the Fed may increase interest rates if the US economy continues to boom. The overall economic environment is considerably improved from 1994 (when bond markets last plunged) because of a lack of inflationary pressure.
GAM’s Jeremy Smouha agrees that the lacklustre euro is hurting the European bond market and shares concerns about possible rate hikes by the Fed. He does, though, expect to see lower bond yields in Europe by the summer and is positioning the GAM bond fund to take advantage of any rally in the European bond markets.
Euroland’s 10-year yields more or less stabilised in March, after rising sharply in February. The yield curve steepened, as yields for shorter maturities fell by 10 to 20 basis points, reflecting the brighter prospects of a rate cut since the departure of Oskar Lafontaine as German finance minister and poor business indicators, especially in Germany and Italy. In this uncertain global context, yields are expected to move sideways.
Despite the expected slowdown in macro-economic growth and lower corporate profits in 1999, there are islands of opportunity in the corporate credits market. One of the most important developments in the euro market this year is the growth in the number of corporate new issues. The volume and amount of new eurobonds in all sectors is conspicuously heavier than issuance in legacy currencies and euro at March 1998.
In addition to activity by frequent issuers such as GECC, GMAC and Ford, the euro has attracted first-time corporate issuers such as Energie, the third largest provincial Austrian electric utility and infrequent and unrated issuers such as Olivetti. The Olivetti 5% ’09 was oversubscribed at launch, when it was marketed as a turnaround story to investors. It is unrated but, according Joseph Biernat at Paribas, would be unlikely to achieve investment-grade status due to the highly subordinated claim on its key business, Omnitel.
Nevertheless, there was strong demand, not only from Italy, but also Germany, France and Benelux, a surprising move down the credit curve by investors who bought it on its name.
Paribas’ Euro bond analysis team believes that single-A corporate bonds offer the best relative value opportunity in the euro credit markets for investors willing to move down the credit curve: “Performance of corporate spreads since the beginning of the year has been excellent, with the best-performing part of the single-A generic curve, the five-year maturity tightening by 25 basis points against the government curve since the beginning of the year.”
Richard Newell is a director of Forsyth Partners in Croydon.