Worried about a currency war? European bonds may be the best bet

London

THE growing threat of a global currency war is spurring the unprecedented European bond rally in more ways than one.

While trade tensions are already sparking a flight of capital into the region's safest assets, the Swiss National Bank (SNB) could emerge as a major buyer of euro-area debt if the situation escalates, racing with the European Central Bank to do this.

While the US-China trade spat has fuelled world-wide market turmoil, it has had the opposite effect on the Swiss franc, an investor haven. The currency's rally to a two-year high is threatening the SNB's goal to spur inflation. The cental bank may thus intervene to rein in the exchange rate by buying euros, and then investing in the region's bonds, said Commerzbank.

Benchmark German yields slumped to a record low of -0.55 per cent this week after the US formally labelled China a currency manipulator, in response to the People's Bank of China's move to weaken the yuan to levels unseen since 2008.

The SNB may have already started intervening - the central bank's sight deposits, which economists consider an early indicator of its currency-market activity, jumped last week in the second consecutive sizable increase.

Christoph Rieger, head of fixed-rate strategy at Commerzbank, said: "The latest foreign-exchange developments could mean the SNB will need to intervene, which means the ECB will be in competition in its demand for European bonds."

If the Swiss central bank starts buying, "you can pick any number" as to how low yields may go, he said.

If the SNB starts actively buying debt, it could find itself vying with the ECB to hoover up the region's sovereign bonds. The euro-area central bank is widely expected to announce in September that it is adding to its 2.6 trillion euro (S$4.01trillion) stockpile of debt in an effort to bring inflation back toward its close-to-but-below-2-per-cent target.

James Athey, a money manager at Aberdeen Standard Investments who has a long position in 30-year German bonds, said: "It adds yet another buyer to the European government bond complex, so in spite of how negative they are, I don't see any let-up in the debt rally."

The threat of a full-blown currency war has risen as central banks are already shifting back into easing mode, with the Federal Reserve cutting interest rates last week and the ECB hinting at its own stimulus measures.

The prospect of the Swiss central bank entering the market means Europe's bond rally may still have room to run, said Allianz Global Investors. The entire German curve now yields less than zero - turning on its head the idea that investors get paid to loan out money - while yields in France and Spain have also dropped to record lows.

Mike Riddell, a money manager at Allianz, said: "The SNB absolutely has the firepower to cause big moves in European government bonds. Bond yields can go significantly lower everywhere if the SNB is doing this." BLOOMBERG