Interest rate volatility to spread to the Eurozone

With the ECB expected first to change its communication emphasis over the summer followed by a move to ‘taper’ its quantitative easing programme moving into 2018, investors should expect the ‘one-way’ trend in Eurozone rates to transition to increasingly ‘two-way’ volatility, much as seen in the post-2013 period following the end of the US quantitative easing programme in 2013.

Like the US in 2012, with real German yields sitting near historical lows, we expect the beginnings of a transition away from ECB President Mario Draghi’s ‘whatever it takes’ policy regime to result in the start of a normalisation in the real interest rates environment within the single currency area in the years ahead.

Such a transition in regimes suggests that government bonds and also, in light of tight spreads, euro-area credit markets may see the ‘coupon plus’ that has characterised returns in the asset classes give way to ‘coupon minus’ return profiles looking ahead.

With historically low yields in the market combined with increasing prospects of volatility greater than seen in recent years, we see the unattractive risk-reward profile plaguing USD fixed income markets spreading to EUR fixed income markets looking ahead.

Emerging market bonds, with spreads still near historical averages, present one of the few, relatively attractive return profiles compared to the broader fixed income universe, both in USD and EUR. Though inflation-linked bonds increasingly price in a more normalised inflation scenario, with the broader fixed income universe appearing to richly price even an attractive outcome in the global economy, relative value in duration hedged, inflation-linked strategies remains intact.

Against this backdrop, we prefer active management to capitalise upon the expected pick-up in interest rate volatility via non-directional strategies within fixed income.

Norman Villamin – Chief Investment Officer Private Banking – Union Bancaire Privée (UBP)