How ECB Rate Cut Affects Bond Investors

The European Central Bank delivered surprised investors yesterday by cutting its benchmark interest rate to zero and expanding its bond purchasing programme

Emma Wall 11 March, 2016 | 3:15PM
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Emma Wall: Hello, and welcome to the Morningstar series 'Why Should I Invest With You.' I'm Emma Wall and I'm joined today by Christine Johnson, Head of Fixed Income for Old Mutual Global Investors.

Hello, Christine.

Christine Johnson: Hi.

Wall: So, what's just happened, the ECB has announced that it's going to have even lower rates in Europe.

Johnson: I think what we have got to actually take from this is that the ECB has remembered what we may be forgot about central banks, which is the element of surprise. And you can see that in how markets have reacted. Everybody was thinking they are going to do more sovereign bond purchases and they are going to cut rates further than they actually did. And, of course, Mario Draghi also made this comment about whether or not there was a need to do any more.

So if that was the low people were expecting, you would have expected the euro to fall and, of course, sovereign bonds to rally and you had exactly the opposite. What he's done instead is, he has actually refocused the central bank and said, we are no longer running monetary policy for financial markets, but we are going to start focusing on is how we can actually get this to work for the real economy.

Wall: Which is, of course, him actually following through a more – he promised all those years ago to do whatever it takes to boost the economy.

Johnson: Exactly. He knows that Europe is a bank-driven economy. You've got to get the lending channel working, and that's exactly what he's taken the focus away from financial markets, and said, we need to get banks lending.

Wall: That’s all well and good for the economy. That's all well and good for the financial sector. But what does that mean for bond investors?

Johnson: Well, there has been a bit of giving with one hand and taking away with the other. If you are a sovereign bond investor, you're probably a little bit disappointed. Yes, the program has got bigger, but he's also introduced another asset class in that he is now willing to buy corporate bonds. So you have kind of had the sovereign bond story fade and you have had them sell off, but you have had corporate bonds in this morning, you can't get hold of those for level of money people really, really want anything which is investment-grade in euro because you've suddenly got a big price-insensitive buyer in the market.

Wall: Now, that's what's happening in Europe, but, of course, you are a Global Bond Investor and, in fact, across all asset classes, and so looking at the world as a whole, we still seem to have this sort of two-speed bond market. You've got Japan and Europe lowering rates. You've got the U.S. raising rates. The U.K. potentially will be raising rates sometime in the next year. How does this effect the way that you run a bond portfolio?

Johnson:  Well, it's really interesting times with the good and the bad bits of that. I think it matters still that nevertheless, you have got Japan and you have got Europe having negative deposit rates and continuing to pursue, even it's on a lesser level, continuing to pursue that policy. You've also got a global money market. If you are a bank in Europe, you can decide whether or not you want to buy a bond, which will have a negative yield on it or if you want to buy U.S. Treasury.

So there will be kind of segmentation where what's going on in monetary policy may not necessarily be reflected further round in terms of bond market. The carry trade is still alive, and if I can buy U.S. Treasury, pay me 2 and something, compared to a European bond, pay me a negative yield, then there is a relative value trade, I'm probably still going to be interested in those U.S. Treasuries.

Wall: Because looking at total return, you've now got a place where prices are rallying in one part of the world, but yields are looking attractive in another?

Johnson: Exactly. It just caps that gap. It just means it's very hard for U.S. monetary policy to kind of escape and go completely on its own track, because you've always got this feedback loop going on around the world where it's the Bank of Japan or the ECB or private investors are still trying to use that relative value and to actually hold on to where you can get positive yield.

Wall: Christine, thank you very much. This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar