By Robin Marshall, director, fixed income research, Global Investment Research
European debt markets have rallied strongly this past month, as the show of unity among European Union leaders behind a massive COVID-19 rescue spending plan and common bond issuance (along with a supportive ECB) dispelled Eurozone break-up worries and bolstered the region’s recovery outlook.
The €750 billion EU package, split roughly evenly between grants and loans, has been viewed by markets as a significant positive for Italy, Spain and Greece. Thus, riskier European bonds have done particularly well lately, with long-dated governments and inflation-linked bonds in Italy and Spain, as well as Eurozone high-yield corporates delivering gains of 7%-17% for the three months through July end, placing them among the 15 best performers for the period (see chart below).
Top 15 bond returns (local currency, %) ‒ Three months ending July 31, 2020
Source: FTSE Russell. Data as of July 31, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
COVID-19 deal brings debt mutualization and reduces default risks
The EU’s fiscal stimulus package has also reduced pressure on ECB monetary policy alone to deliver a post-COVID economic recovery, when interest rates are stuck at the lower bound (currently a deposit rate of -0.40%). The relief fund targets hardest-hit Italy and Spain, diminishing market fears of further economic divergence post-COVID. The most significant development, however, was the united front shown by Germany and France behind a plan to finance the deal via a mutualization of debt, so that all EU nations are jointly and severally liable for the funds.
Though continental Europe suffered far worse than the rest of the developed world in the early stages of the COVID-19 outbreak, containment efforts have made good progress, and high-frequency data indicate the region’s economies are rebounding faster than expected. Against this improved economic and policy setting, the euro extended its post-lockdown rally in July, particularly versus the US dollar.
Eurozone real effective exchange rate (rebased) rides recovery in confidence
Source: FTSE Russell. Data through July 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Euro strength and narrower Eurozone spreads go hand in hand
The positive relationship between euro strength and peripheral European bond performance is longstanding. During risk-on phases, peripheral spreads have typically narrowed when the euro strengthens versus the US dollar. Big risk-off phases have tended to favor the US dollar, weaken the euro and widen peripheral spreads.
A similar dynamic has played out this year. Renewed optimism over the EU’s handling of the virus, the ECB’s upgraded QE programs and the joint COVID-19 stimulus fund has tightened yield spreads over Bunds, after the initial widening in spreads in March, when the dollar spiked on fears of global dollar-funding shortages.
Crisis? What crisis?
Also worth noting, the pandemic-induced widening in 7-10yr Italian, Spanish and French government yield spreads in March pales in comparison to what occurred during the European sovereign debt crisis in 2011-2012. That crisis presented the first existential threat to the Eurozone, when the ECB had no authority to even pursue QE sovereign bond purchases.
7-10yr peripheral European yield spreads tighten vs German bund equivalent (basis points)
Source: FTSE Russell. Data through July 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
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