How should investors respond to ECB tapering?

Added 10th July 2017

The improving economic outlook in the euro area has prompted the European Central Bank to consider reining in its monetary stimulus. How should investors respond to the prospect of monetary tightening in Europe?

How should investors respond to ECB tapering?

When ECB-president Mario Draghi recently said that “all signs now point to a strengthening and broadening recovery in the euro area” at an ECB meeting in Portugal, equity and bond markets reacted instantly. The market response was quickly dubbed the ‘mini-Tantrum’ by analysts, as it reminded market watchers of the 2013 Fed Taper Tantrum.

Deutsche Bank analysts decided to add some fuel to the fire, writing in a note shortly after the ‘mini-Tantrum’ that “it could well be that we look back on this week at the end of the year as the one in which the tide finally turned.”

But Leif Hasager, CIO at the Danish wealth manager Formuepleje, doesn’t think there’s that much to worry about.

“What Draghi said confirmed our thesis that things are going well in Europe,” he told Expert Investor. “He was just telegraphing to markets that that normalisation of interest rates is going to happen”

Self-sustained recovery

When the ECB released the minutes of the previous ECB meeting in Tallinn in early June, it became clear that was indeed what Draghi had intended to do.

“If rates go up because growth is good and the economy is improving, that should more than compensate for the negative price impact of rate hikes” - Leif Hasager

The minutes basically echoed Draghi’s Sintra comments, referring to “a possibly stronger than expected economic upswing” in the eurozone, which was “raising the prospect of an increasingly self-sustained recovery over the medium term.”

If the European recovery indeed becomes “self-sustained”, this implies central bank asset purchases are no longer needed.

Bank stocks extended recent gains on this prospect, while bond proxies took another hit. Government bond yields also advanced further, with the 10-year German Bund yield exceeding the psychologically important 0.5% mark for the first time since January 2016. By Friday afternoon, 10-year Bunds traded at 0.571%, with yields having more than doubled in less than two weeks.

Short-duration consensus

The recent market moves have further darkened prospect for duration, investors believe. Being underweight duration has therefore fast become a consensus trade.

“The ECB paring back its asset purchasing programme won’t do much to the short end of the curve, and investors are therefore advised to keep with a relatively short-duration,” says Hasager.

 

“In our bond portfolio, we have an average duration of 2-2.5 years now, and we even hedge out the interest rate risk via swaps,” he adds. 

Luis Miguel Alvarenga, portfolio manager at BPI Gestao de Activos in Lisbon, “marginally cut some duration trades” amid the mini-Tantrum. “I struggle to find value in core government bonds,” he says.

Alvarenga has an allocation to Portuguese government bonds instead, which he increased in January beforing paring it back after the French elections. And that trade didn’t do him any harm. While most other government bond yields, including Spanish and Italian 10-year yields, have risen, Portuguese government bond yields have come down.

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