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The Euro-Zone: A rising tide

A flood of global liquidity is floating all of the euro-zone’s boats – even those, like the Netherlands and France, whose economies have taken a turn for the worse. Lynn Strongin Dodds looks at the dynamics

Despite the deteriorating economic picture in France and the Netherlands, bond yields in both countries continue to plumb new depths. This is unlikely to change any time soon as central banks across the globe maintain their collective loose hand on monetary policy.

The most recent moves were in May by the European Central Bank (ECB), which reduced its main interest rate to 0.5%, and the US Federal Open Market Committee, which reaffirmed its $85bn-per-month (€65.6bn) bond buying programme. Both of these annoucements came on the heels of the Bank of Japan’s immense $1.4trn liquidity injection.

Add all these developments together and the search for yield is on. Core euro-zone countries, in particular, have been and will continue to be the main beneficiaries. By the end of April French, Austrian and Belgian 10-year yields had fallen to new basement floor levels of 1.65%, 1.44% and 1.90% respectively, while Dutch 10-year notes slid to 1.70%. Meanwhile, the Italian/German 10-year yield spread narrowed to its tightest since July 2011 at 251 basis points. Spanish 10-year yields fell below 4% for the first time since October 2010, and comparable Portuguese yields also hit two-and-a-half-year lows.

“In many ways, it is a straightforward story,” says Nicolas Forest, global head of fixed income at Dexia Asset Management. “The 10 and 30-year yields, especially on French bonds, have reached record lows even though the political and economic situation is worsening. A combination of lower interest rates and quantitative measures from the ECB and BOJ are creating an excess of liquidity. I think this will not change because we expect to see a new accommodation from the Bank of England as well as the ECB by the end of the year.”

Myles Bradshaw, executive vice president and portfolio manager at Pimco echoes these sentiments. “Europe is not in isolation,” he says. “The BOJ’s recent move will lower yields on domestic bonds and as a result investors will look at foreign markets such as France and the Netherlands for higher returns. These countries may be facing an economic slowdown but they are in relatively better shape than the peripheral countries such as Spain and Italy.”

Andrew Mulliner, portfolio manager on the rates desk at Henderson Global Investors, also notes that France and Netherlands still represent large, liquid and highly-rated bond markets that offer a reasonable yield – at least relative to Germany.

“Simply put, there are not enough Bunds or Finnish government bonds in the world to satisfy the demand that still exists for safe sovereign debt and with the increase in liquidity investors seem prepared to take a bit more risk for a slightly higher return,” he says.
Mulliner believes that as long as there is faith that the ECB will act as a backstop to sovereign markets via the OMT programme, the rationale for holding this debt remains.

“Of course, should ratings agencies aggressively downgrade these sovereigns then certainly this would have the potential to undermine demand,” he says. “But this still feels a reasonably long way off, so one would expect demand to remain robust. Remember also that the policies recently enacted by the BOJ are expected to encourage large Japanese institutions to increase their holdings in foreign bonds over the medium term and both France and the Netherlands have in the past been seen as attractive homes for this money.”

Even before the BOJ announcement, Japanese investors poured ¥166bn (€1.3bn) into German Bunds as well as ¥286bn and ¥900bn into French and Dutch bonds, respectively, in January and February of 2013. Life insurance companies, which are heavily exposed to long-dated Japanese government bonds, are likely to continue being the most active. The jury is out over banks, which are the country’s other major investors but in less need of diversification.

Not everyone though is focused on the technical aspects. Some market participants are worried about the underlying fundamentals of these countries.

“I expect that investors will wake up one day and say, ‘Why should I buy all this risk without getting paid anything?’” says Poul Thybo, senior investment manager at Austrian pension fund APK. “France and Holland have their own problems but they are being put into the same core basket. One of the big questions is what will happen to France if Spanish banks blow up. Germany will be left as the only real core-country because once the costs of keeping the euro-zone together get too high it is the only one that can credibly  choose to reintroduce the Deutschmark. Investors will be willing to pay something for this option and this will keep German yields low.”

Despite being aware of the weights of each country in the benchmark, APK feels no obligation to hold bonds from countries for which the risk-reward ratio is low, as it sees things.

“APK has thus moved from being overweight France and Holland pre-crisis to having a substantial underweight right now,” says Thybo. “The opposite picture of this allocation is that Italy and Spain have been moved from having no weight to almost benchmark weight.”

Neil Williams, chief economist at Hermes Fund Managers is also circumspect.

“There are two forces at work,” he says. “The first is the sheer weight of buying driven by quantitative easing elsewhere. But we are also entering the second phase of the euro-zone crisis. There is a shift in the macro strains taking place from the peripheral countries to those, such as France, who are footing the bill. This is why I am increasingly concerned about the macro-economic picture and the fact that France in particular is addressing its underlying problems too slowly.”

One of the main problems, Williams suggests, is the country’s lack of competitiveness. It is down 7% compared with its trading partners since the euro came into being. By comparison, Portugal’s loss is half of this, yet Portugal is a bailout country rated 10-11 notches lower. German exports have grown three times as much as those from France over the past decade and there is no sign of the trend reversing. The country saw its exports contract by 2.4% in February, the same pace as in January, while imports only fell by around 1.7%. In addition, public spending has soared to 57% of GDP – a euro-zone record – and public debt is expected to reach 94% of GDP next year.  

The Netherlands has also lost its edge against its trading partners, but its economic foundation is at least more robust than France. According to a report from the European Commission, real GDP growth will be -0.8% this year instead of the -0.6% previously predicted – but there will be green shoots of recovery in the second half of the year mainly due to strong exports. The bond market also benefits from having strong domestic support from its institutional investors.

“It may be smaller than France but is still attractive in that it offers investors the two main things they are looking for – quality and liquidity,” says Franck Dixmier, chief investment officer fixed income Europe, Allianz Global Investors.

In short, the Netherlands and especially France present investors with a straight-out fight between (impressive) technicals and (worsening) fundamentals – in many ways characteristic of financial markets as a whole. As the ‘melt-up’ in so many of those markets is showing, investors can experience a lot of pain struggling against those technicals.

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