Fixed Income Focus - November 2020

Chart of the month: less disparity on 10-year yields in the euro zone (pdf document at the end of the article)

The ECB's chief economist wanted the yield spreads between eurozone countries to return to their pre-crisis levels. This has now been achieved and the ECB has reduced its bond purchases accordingly. However, it remains vigilant to the situation. The 10-year yields of all eurozone countries are close to their historical lows.

Central banks: more stimulus in December

·       US Federal Reserve:

•       We do not expect any change in the policy rates. The asset purchase programme has become the main tool of monetary policy.

•       More easing is coming in December in our view.

o   The Fed may slow the current pace ($40bn per month) of purchases of Mortgage Backed Securities as it now holds a third of the market, and at the same time increase its purchases of Treasury bills (currently $80bn per month).

o   It could buy bonds with a longer maturity as the Treasury will increase the maturity of the bonds it will issue next year.

·       European Central Bank:

•       ECB members are unanimous that further stimulus measures are needed because the economic outlook is gloomy and inflation is too low. A strong support has therefore already been pre-announced, at the risk of disappointing the market.

•       It could take the form of :

o   An additional 500 billion euros for the PEPP (bond purchase programme to support the countries most affected by the pandemic) to bring it to 1.75 trillion; an extension of its validity by six months, thus until the end of 2021; an increase in the duration of the portfolio.

o   Doubling of the "classic" bond purchase programme (which has no end date, unlike the PEPP) of 20 billion euros at present.

o   Better conditions on TLTROs, these loans to banks at advantageous terms (rates up to -1%) as long as they lend to the real economy (companies, households).

•       We do not envisage any policy rate cuts.

Bond yield targets

•       Long-term bond yields were volatile in the first two weeks of November, hesitating between falling because of new lockdowns/restrictions and rising as a result of advances in vaccines. This volatility is expected to persist in the short term.

•       On a 12-month horizon, the economic recovery and the numerous bond issues expected in 2021 suggest that US and German long-term yields should edge higher slightly (see table below). Central banks will be keen to curb this rise.

•       Short-term bond yields are expected to remain stable over the next year in the euro area and the United States, due to a lack of central bank stimulus.

The emerging market for bonds issued by the European Union

•       The EU issued four bonds for a total of €31bn, two on 20 October and two on 10 November, with maturities of 5, 10, 20 and 30 years, to finance the European recovery plan. Demand was extremely strong, 13 times higher than supply on average. Investors were attracted by the Socially Responsible Investment side of these bonds, as they are labelled 'Social bonds', and the yields were attractive in relation to the issuer's credit rating.

•       These are the first large issues in the EU. The EU had already issued around 40 bonds in the past, but most of them were very small. The EU is expected to raise nearly 900bn over the next five years. The funding will go to the countries most affected by the health crisis. It marks a first step towards tax transfers between countries.

•       The EU is rated AAA(Moody's)/AA(S&P)/AAA(Fitch)/AAA(DBRS). S&P has a positive outlook and may in fact improve its rating in the coming quarters. The EU is therefore part of the very select club of AAA issuers in the eurozone, along with Germany, the Netherlands and Luxembourg. Given the current shortage of AAA sovereign bonds, this new issuer offers new opportunities for institutional investors forced to hold high quality bonds.

•       With a market close to 900 billion at term, EU bonds could compete with German bonds to be the eurozone's benchmark safe haven. That said, the German market should remain popular with investors because of its rating, its size (1.7tr euros) and its liquidity.

Our views