Statement

The Fed and the ECB are taking different paths

The current market environment is quite challenging for bond investors and can be very punishing in the short term, says Volker Schmidt, Senior Portfolio Manager at Ethenea. However, the two major central banks – the Fed and the ECB – are taking different approaches in dealing with this.

March was dominated by the central banks. First, the European Central Bank announced at the beginning of March that it would step up its asset purchases to enable it to respond better to tougher financing conditions (increase in yields). The U.S. central bank followed suit in the week after, making it clear that, although it had revised its growth forecasts upwards considerably and expects higher inflation rates in future, it would be sticking with its accommodative monetary policy for the time being. In concrete terms, the key rate remains in the range of 0% to 0.25% and is not expected to be raised before 2023. The bond purchase programme, which currently stands at USD 80 billion for sovereign bonds and USD 40 billion for mortgage-backed securities, also remains untouched.

“Thus, the two major central banks are taking different paths,” says Volker Schmidt, Senior Portfolio Manager at Ethenea. “While the European Central Bank announced that it would significantly increase its asset purchases under the Pandemic Emergency Purchase Programme (PEPP) from the current level of almost EUR 20 billion a week in an effort to counteract a rise in bond yields, the Fed sees no need for action yet, arguing that a moderate rise in yields is a positive sign or rather a consequence of an economic upturn.”

Steeper yield curve in the US

Accordingly, the yield curve in the U.S. became much steeper (the difference between 2-year and 10-year yields rose by 30 bps to 160 bps) and is therefore trending higher than it has since the end of 2015. The spread between Treasuries and Bunds is also widening further. While U.S. fixed-income securities are now yielding around 1.75% (compared to around 1.0% in January), the yield on German Bunds remains negative at around -0.25% (versus -0.55% in January).

Rising dollar

The U.S. dollar gained almost 3.0% and is thus around 4.0% up on the euro since the beginning of the year. The growth in yields makes U.S. Treasuries increasingly attractive to international investors and, at the same time, progress on the vaccination front in the U.S. should speed up the reopening of the economy. Both are giving the U.S. dollar a boost in the short term. In the long term, the high budget deficit and a current account deficit are likely to put further pressure on the greenback.

US investment grade bonds under pressure

U.S. investment grade bonds remain under pressure and have lost 2% over the course of the month, bringing them to -5% year-to-date. Unlike at the beginning of the pandemic, the U.S. central bank seems to be making no move at present to help investors with further bond purchases. Volker Schmidt : “Normally, an increase in U.S. yields is accompanied by a reduction in credit spreads – i.e. the premium on corporate bonds over sovereign bond yields – as confidence in the economy and companies’ creditworthiness returns. However, spreads are already very low, which is due to the Fed’s swift and bold intervention at the beginning of the crisis, with the result that they couldn’t really narrow further in March. This leaves little room to cushion the rise in interest rates associated with the economic recovery. At the same time, U.S. high yield bonds have benefited, with the spreads on bonds rated between BB- and CCC- tightening in March by around 5 bps on average to 3.2%. It’s a different story for bonds from European issuers. These benefited from the ECB’s support and actually gained around 0.2% on average.”

The current market environment is therefore quite challenging for bond investors and can be very punishing in the short term. Volker Schmidt : “At the same time, active portfolio management also provides opportunities to absorb short-term setbacks in the bond market – for instance, using an active duration overlay and fundamental security selection.”