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The official blog of BNP Paribas Asset Management

The outlook for eurozone inflation-linked bonds

A V-shape economic recovery in the eurozone looks unlikely, while member states continue their marathon search for a compromise on how to fund the reconstruction. The poor outlook for the economy and inflation, and the ECB’s asset purchases, should keep eurozone government bond yields low and cap the risk premiums on ‘peripheral’ bonds.

In the near term, we expect the ECB’s EUR 120 billion envelope for asset purchases on top of its EUR 20 billion monthly Public Sector Asset Purchases (PSPP) and its EUR 750 billion Pandemic Emergency Purchase Programme (PEPP) to keep eurozone government bond yields low. The package should also suppress volatility in ‘peripheral’ eurozone government bonds.

During the liquidity crunch in March, bid-offer spreads widened significantly, even for core eurozone inflation-linked bonds (‘linkers’). In the first half of April, liquidation flows in eurozone inflation-linked bond markets slowed. Optimism about a potential reduction in lockdown measures to reopen the economy caused valuations of linkers to fall. Easing measures provided by the ECB also generated more two-way interest in the market, as well as a partial normalisation of liquidity.

The return to a more normal functioning of the sovereign bond market, and continued purchases by the ECB should keep fiscal financing costs low for eurozone members, including the southern (‘peripheral’) countries with lower sovereign credit rating and higher debt levels.

What about eurobonds?

More pertinent in the medium term, decisions on mutual funding assistance among the member states to fight the virus outbreak could have important political consequences.

The coronavirus is a symmetric exogenous shock. The loss in economic activities is not the fault of the countries who suffer from it. Member states will have to act with sufficient strength and speed to prevent the economic disruption morphing into a prolonged recession, and thereby preventing a permanent destruction of productive capacity and the fiscal base.

However, not all members have the fiscal space to fight the crisis. And the virus, at least for now, is hitting those countries hardest which had already been weakened by the previous crises.

Italy, for example, is forecast to see its debt-to-GDP ratio rising to 150%. In contrast, at 66%, the rise in Germany’s debt would be relatively contained and the Netherland’s will rise to roughly 70% (see Exhibit 1).

The vulnerable southern countries whose debt levels would raise questions about fiscal sustainability would appear to have less room for fiscal measures. Having given up monetary policy independence, they will have to rely on a fiscal response and massive coordinated support at the eurozone level.

Without coordinated support and equal access to cheap financing, divergences are going to widen, and the economic inequity could deepen the divide within the eurozone.

A lack of coordination equals higher political risk

Indeed, as Italy faces its most severe crisis since WWII, there is a rising feeling among even its pro-European elite that the country is being abandoned by its neighbours. Some may conclude that membership of the single currency brings no benefits, and Eurosceptic sentiment can rise.

This could lead to a resurgence of political support for the radical Lega party and fan the flames of an ‘Italexit’. Countries, led by Italy and Spain, are proposing debt mutualisation through joint debt issuance dubbed ‘coronabonds’. The idea is anathema to member states including the Netherlands.

On 9 April, Eurogroup finance ministers agreed an emergency rescue package. It is intended to combat the consequences of the pandemic. Discussions on a recovery plan will come later. The main measures (for a total of nearly EUR 550 billion) are:

  • EUR 100 billion to finance partial unemployment and avoid job losses (the SURE programme)
  • EUR 200 billion of financing for companies with a focus on SMEs by the EIB
  • EUR 240 billion in loans via the European Stability Mechanism (ESM) with mild conditionality: the only requirement is that member states commit to using the money to finance domestic healthcare, cure and prevention-related costs. Access will amount to 2% of the member’s GDP as of end-2019
  • It was decided to work on a Recovery Fund which will be temporary and targeted.

Only fiscal risk-sharing can save the euro

While the immediate measures should help businesses, workers and sovereigns to recover from the c crisis, the questions on how the eurozone would pay for a recovery plan remain unanswered. The announcement does not mention creating coronabonds. Issuing debt jointly and moving towards budgetary integration is primarily a political decision. The Eurogroup passed the parcel back to the heads of state; they should decide whether ‘innovative financial instruments’ should be employed.

The eurozone has shied away from the fact that the currency union cannot succeed without a fiscal union. Today, the rising risks to debt sustainability and the associated political consequences have put the topic of fiscal risk-sharing front and centre.

Profound divisions remain on how large and how urgently it needs to be, and how the costs will be shared. Politicians will need to overcome these divisions to preserve the euro.

How are we positioned in eurozone inflation-linked bonds?

The market will likely remain nervous about the impact of COVID-19 on public finances, bond issuance, debt sustainability and sovereign credit ratings.

In an optimistic scenario, economic shutdowns end and growth rebounds faster than anticipated, EU leaders enact a coordinated response to mutualise fiscal costs, and the ECB looks beyond the immediate rebound and continues with its asset purchase programmes.

In such a scenario, core government bond yields will rise as the market prices in the improved inflation and growth outlook. ‘Peripheral’ bond spreads tightened.  

In a pessimistic scenario, where a deepening recession is not met by decisive solidarity financing, the weaker member states could face sovereign credit downgrades. The political divisions within the eurozone could grow, and nationalism could return.

Investors will worry increasingly about euro breakup risk re-emerging. Core government bonds, particularly German Bunds, will rally as investors flock to safety amid higher debt redenomination risks. ‘Peripheral’ yields will skyrocket, especially if Italian debt is downgraded to below investment-grade.

Inflation-linked bonds will likely underperform as questions regarding what the bonds’ linkage to euro HICP inflation really means will find no immediate answers.

A scenario between two extremes

Concerns about a second wave of infections and still limited testing, surveillance capacity and insufficient medical supply suggest that some degree of social lockdowns will likely persist.

A V-shape recovery is therefore unlikely. Member states will continue their marathon search for a compromise on how to fund the economic reconstruction. The poor economic and inflation outlook, and the ECB’s asset purchases, will keep government bond yields low, and cap ‘peripheral’ spreads.

With ‘peripheral’ spreads currently still relatively tight on a historical basis, and the risk of redenomination, the risk-reward of owning ‘peripheral’ bonds for carry purposes is unattractive. As such, we will continue to look for opportunities to exist our positions.

We maintain a short bias in eurozone BEI as we expect deflationary impacts from demand destruction to overwhelm supply-side inflationary effects in the near to medium term.

Also read What now for US inflation-linked bonds?

This is an extract from the inflation-linked bonds quarterly review for second quarter 2020.


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialized or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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