Improving European outlook casts a shadow over region’s bond market

Rising optimism over the recovery of the coronavirus in Europe could cause problems for the region’s government bonds as some investors exceed maximum pessimism on the continent’s economy.

After browsing volatile markets together during the first stage of the pandemic in 2020, European and US government bonds have gone their separate ways this year.

U.S. Treasuries suffered their worst sell-off in decades in the first quarter as investors braced for an economic surge, while the blow to eurozone government bonds was much milder, due vaccination delays, new social restrictions and signals that the European Central Bank is ready. act to ward off rising bond yields.

But now some analysts believe that improving European economic data and accelerating the region’s immunization program will herald a further rise in government bond yields, which set the baseline for borrowing costs and boost debt. euro against the dollar.

“The big surprise of the first quarter was how quickly the United States reopened,” said Jim Caron, portfolio manager at Morgan Stanley Investment Management. “Once the price of this surprise hits full price, the market starts looking for the next big surprise. It is the virus that dictates where this surprise comes from. All you need to ask yourself is where the data is going to improve next. It’s pretty obvious it’s in Europe. “

The transatlantic bond yield spread reached 2 percentage points in mid-March, the widest spread between U.S. Treasuries and German Bunds since the pandemic forced bonds to regroup in February 2020.

The stability of euro area government bonds is largely due to the ECB’s reaction. Fearing that the fall in US bonds could seep too far into European markets, raising borrowing costs in a difficult economic environment, the ECB stepped up the pace of its bond purchases in March.

But in addition, Europe has been slow with vaccinations. By mid-February, the United States had delivered about 16 doses per 100 people, triple the proportion that had been provided to EU residents, according to figures from the Our World in Data project at the University of Paris. ‘Oxford.

Now Europe is picking up the pace. Germany set a record 719,000 daily doses last week, and the bloc has now vaccinated 23 out of 100 people. Recent economic data has proven to be stronger.

Line graph of daily number of Covid-19 vaccines administered per 100 people showing The pace of vaccination in the euro area has increased

“I would agree with the argument of maximum pessimism,” said Ella Hoxha, fixed income portfolio manager at Pictet Asset Management. “The general roll-out of vaccinations in Europe is accelerating and has probably not had enough airtime.”

Already, European government bonds are under some selling pressure as the German 10-year yield hit its highest level since the end of February at minus 0.25 percent. Italian bonds are also at their lowest in a month, hitting a high of nearly 0.79% on Thursday. The euro lost nearly 4 percent against the dollar in the first quarter, but gained ground in April.

Against the dollar line chart showing the euro regaining momentum after falling

The arguments for a stronger euro recovery are based on the pace of vaccinations. Bank of America monetary strategist Athanasios Vamvakidis said faster vaccinations were already having an impact. For these gains to be sustainable, he says, “vaccination should accelerate quickly enough to save at least part of the summer tourist season. . . It is feasible, but not acquired ”.

Even in the best-case reopening, analysts don’t expect a bond sell-off on a scale similar to the Treasury bill leak earlier in the year. ECB bond purchases continue to weigh on rising yields and inflation expectations in Europe are firmly entrenched.

“European government bonds should perform better. There is no realistic result for high inflation in Europe. It is very, very difficult to imagine one, ”said April LaRusse, Head of Investment Specialists at Insight Investment.

The reopening could also pose traps in the ECB’s path if it tries to bring the market back to normal. “They have to navigate this time when we are starting to see a take off in rate optimism and volatility,” said Hoxha of Pictet.

The central bank is meeting next week. “There will be a communication challenge for the ECB,” said David Riley, chief investment strategist at BlueBay Asset Management. “It will be seen by some market players as on the way to reducing its monetary support.”