Bond yields drop with ECB doves still in the driving seat


Craig Inches, Head of Short Rates and Cash

20 July 2017

The doves were out in force at this month’s European Central Bank (ECB) meeting, resulting in European government bond yields falling in the aftermath of the announcement. Despite a robust outlook for European growth, prices remained volatile and bond yields trended lower as markets hung off Mario Draghi’s every word.
It is evident that the doves are in the driving seat for now, and that inflation continues to dog ECB hopes of unwinding monetary policy any time soon.  Without the convincing and consistent reflationary data which the ECB is looking for, it will be difficult for bond yields to trend higher over the medium term. However, should we see a sustained pick up in the wage growth and price growth which the ECB are monitoring, this would be a game changer and we would expect any sell off in longer dated assets to be compounded by an unravelling of long positions as the ECB signals an unwinding of stimulus.
While the fallout from this ECB conference is likely to be the biggest driving force for bonds this week, RLAM’s fixed income team see three other key trends which are shaping markets:
1. Gilts yields drop (for now)
Gilts have seen a tepid rally this week, thanks to inflation figures which came in slightly lower than the market was expecting, with declining petrol prices a key factor. With the price of oil now pushing back up to $50 a barrel, this dip is likely to be short lived, and we expect stronger inflation numbers for July. This boost for conventional government bonds is already running out of steam, and so we expect gilt yields to trend slowly higher in the second half of the year.
2. Credit spreads could tighten further
Investment grade credit spreads are nearly as tight as they’ve ever been since the financial crisis, thanks in part to the continued absorption of new issuance into the market, adequate demand in secondary markets and a recent compression thanks to the rise in government bond yields. In our view though, the very low level of defaults in investment grade credit suggests that these spreads could tighten slightly further and still represent good value. 
3. Issue now to beat the taper
With the ECB’s decision on tapering still likely to arrive this Autumn, ahead of the inevitable effect this news could have on markets, in European credit markets new deals continue aplenty. Support for these European corporate bonds is being propped up by the demand for assets offering a reasonable yield. Thanks to the steepness in European yield curves, longer maturity tranches of new deals continue to be heavily oversubscribed.

The doves were out in force at this month’s European Central Bank (ECB) meeting, resulting in European government bond yields falling in the aftermath of the announcement. Despite a robust outlook for European growth, prices remained volatile and bond yields trended lower as markets hung off Mario Draghi’s every word.

It is evident that the doves are in the driving seat for now, and that inflation continues to dog ECB hopes of unwinding monetary policy any time soon.  Without the convincing and consistent reflationary data which the ECB is looking for, it will be difficult for bond yields to trend higher over the medium term. However, should we see a sustained pick up in the wage growth and price growth which the ECB are monitoring, this would be a game changer and we would expect any sell off in longer dated assets to be compounded by an unravelling of long positions as the ECB signals an unwinding of stimulus.

While the fallout from this ECB conference is likely to be the biggest driving force for bonds this week, RLAM’s fixed income team see three other key trends which are shaping markets:

1. Gilts yields drop (for now)

Gilts have seen a tepid rally this week, thanks to inflation figures which came in slightly lower than the market was expecting, with declining petrol prices a key factor. With the price of oil now pushing back up to $50 a barrel, this dip is likely to be short lived, and we expect stronger inflation numbers for July. This boost for conventional government bonds is already running out of steam, and so we expect gilt yields to trend slowly higher in the second half of the year.

2. Credit spreads could tighten further

Investment grade credit spreads are nearly as tight as they’ve ever been since the financial crisis, thanks in part to the continued absorption of new issuance into the market, adequate demand in secondary markets and a recent compression thanks to the rise in government bond yields. In our view though, the very low level of defaults in investment grade credit suggests that these spreads could tighten slightly further and still represent good value. 

3. Issue now to beat the taper

With the ECB’s decision on tapering still likely to arrive this Autumn, ahead of the inevitable effect this news could have on markets, in European credit markets new deals continue aplenty. Support for these European corporate bonds is being propped up by the demand for assets offering a reasonable yield. Thanks to the steepness in European yield curves, longer maturity tranches of new deals continue to be heavily oversubscribed.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.