By Martin Harvey
The ECB made a potentially significant change of approach at their April meeting, stating for the first time that quantitative easing (QE) is a realistic policy prospect in coming months. Previously, Mario Draghi had refused to be pinned down on the viability of such a policy, but the persistent undershooting of inflation data in recent months has heightened the governing council’s alertness.
Whereas deflation risk is still minimal in the ECB’s opinion, the prospect of prolonged below-target inflation also threatens the mandate, and Draghi was keen to point out that the ECB stands ready to defend against this. The euro exchange rate also received extra column inches in the introductory statement, and the verbal threat of unconventional measures likely has the currency in mind, given that the euro has remained strong in spite of divergent interest rate expectations versus other economies. In truth, the introduction of quantitative easing is still a distant prospect but the fact that it has entered the discussion is a welcome progression which in many investors’ eyes is long overdue.
The impact of any ECB QE measures will depend on the nature of the policy, but could potentially provide a further boost for peripheral bonds. Tapering frightened the bond market during 2013 but peripheral bonds remained relatively well-supported through that time. The market in general is now more comfortable with the gradual reduction of US QE, but it will be interesting to see how well the market behaves when it is no longer receiving a regular liquidity boost.
The technical picture supporting the peripheral bond market continues to be supportive of tighter spreads. Of course there are always risks given questionable long-term debt sustainability, but while growth is improving we see potential for further gains. The next psychological barrier for the 10-year Spanish spread is 150 basis points, but it could easily move lower than that in the coming months.
In the periphery, we feel Ireland offers poor value at current spreads versus Italy and Spain. Greece will likely issue a bond in Q2, and this will likely be well received. It is very difficult to argue that Greek debt levels are sustainable, but most of this debt is owed to official sources with long maturities, with significant periods even before interest is payable. Therefore a short-dated bond issue is arguably a good investment, but we have to remember that the long-term fundamentals remain poor. The biggest risk faced in the short-term is political risk, which has been low of late but could arise at any time.
Martin Harvey is a fixed income fund manager at Threadneedle Investments
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