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Wake-up call for investors as ECB disappoints

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Bond markets were given a glimpse of what could be in store once the ECB starts unwinding QE this week, but with speculation still rife as to when it will end, many are unprepared for what lies ahead.

[LONDON] Bond markets were given a glimpse of what could be in store once the ECB starts unwinding QE this week, but with speculation still rife as to when it will end, many are unprepared for what lies ahead.

Ten-year Bund yields crept back into positive territory in recent days, the first time since July, after the central bank failed to deliver on expectations on September 8 that it would extend quantitative easing beyond March 2017.

This was a wake-up call for investors who had been lulled into a false sense of security in recent months as ECB bond buying appeared to trump any market concerns.

"Some of what we have seen in the last few days clearly reflects some uncertainty around the theme of central banks running out of ammunition or approaching the end of their easing cycles," said David Riley, head of credit strategy at Bluebay Asset Management.

It would not be the first time that markets are caught out by central banks. Ten-year US Treasuries rocketed from around 1.4 per cent to almost 3 per cent in less than four months after the US Federal Reserve said in May 2013 that it would reduce its bond buying.

Investors can position portfolios for tapering by selling their long-end bond holdings and buying short-duration debt, according to two investors, as bond yield curves will become increasingly steep as the price of longer-duration notes fall.

"Realistically, this will be done through swap rates rather than actually buying and selling the bonds," said an investor. "The difficult part is knowing where on the curve the tipping point is - where will it start to steepen?"

But for all the disappointments following the ECB meeting, many still believe that tapering is not the most likely scenario.

"The market probably now needs to start debating when that tapering may occur," said Tanguy Le Saout, head of European fixed income at Pioneer Investments.

"Rather than blindly believing that quantitative easing will forever be extended." But many investors are still banking on a continuation. "There won't be a hard stop," said Mr Riley. "I wouldn't discount the idea of happening in March but it's not the base case. Tapering is going to imply higher yields and that isn't priced into the market."

And while the ECB features high on investors' radars, there may be another disruption to the eurozone bond markets well before March 2017 - as the Bank of Japan is due to meet next Tuesday to discuss a policy change that has the potential to reverberate globally.

It is certainly possible that the BoJ announces plans to target specific parts of the Japanese government bond curve with its asset purchase programme. This could send Japanese investors - who have long snapped up international bonds because of JGB's lowly yields - flocking back to their sovereign's debt.

"Japanese investors are important buyers of euro government bonds," said Antoine Bouvet, a rates strategist at Mizuho. "If the BoJ changes policy in a way that steepens the JGB curve at the long end, some buyers will be less active in the euro market. This will put upward pressure on yields."

While this has the potential to hurt European investors, it could be a boon to the ECB, which has struggled to find debt to buy that yields enough to fit within its self-imposed limitation of only buying debt that yields more than the -0.4 per cent deposit rate.

And the ECB still has a few more strings to its bow if it does decide to keep quantitative easing going. "There is still room for the ECB to manoeuvre," said Mr Riley. "We have the Bank of Japan buying equity ETFs. I don't think that will happen quite yet with the ECB, but senior bank debt could be an option."


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