Strong global growth and steady Fed tightening have pushed bond yields to around their highest levels in several years. Even so, the very easy monetary policy in the Eurozone and Japan has exercised some restraint on the rise in global yields. That is partly because it has spurred large outflows from Japan, and even more so from the Eurozone, into global bond markets [see Chart 1]. Since the ECB started its sovereign QE programme, it has bought over €2tr of bonds, while net bond outflows from the Eurozone have amounted to a mammoth €1.5tr. Indeed, Eurozone investors now own as many US bonds as Japan and China combined. How will these outflows react to the end of the ECB’s QE (which we expect by year end)?
Bond outflows from the Eurozone have reflected both foreigners reducing their holdings of Eurozone bonds, and Eurozone investors increasing exposure to foreign bonds. Institutional investors such as pension funds and insurers have been investing abroad, but the lion’s share of that buying has come from mutual funds. They have bought over €900bn of foreign bonds since the start of the ECB’s sovereign QE programme, while keeping their holdings of Eurozone bonds little changed. The result is that well over half of their bond holdings are now invested abroad [see Chart 2], albeit a quarter of investors in these mutual funds are also from outside the Eurozone. To make an inexact comparison, only a little over a tenth of US bond mutual fund assets are in the ‘Global Bond’ category. And the large increase in overseas bond holdings by Eurozone mutual funds has come at a time when their share of overseas equities has been little changed. Over the same period, the overseas share of bond portfolios held by Eurozone banks and insurers has increased, but to a much lesser degree.
There are two main narratives for Eurozone bond outflows – a simple displacement effect from QE, and a reflection of the yield advantage of owning foreign bonds – although the two are of course related. Enormous buying of government and corporate bonds from the ECB at a time of relatively restrained government deficits has pushed the previous holders elsewhere, including into foreign bonds. This portfolio rebalancing is the textbook intended result of QE. With net QE purchases set to end this year, this driver is waning, and indeed foreign selling of Eurozone bonds has been steadily moderating [see Chart 3].
The second driver is the yield advantage of owning foreign bonds. On a headline basis, this remains ample and indeed rising, with spreads of US Treasuries to Eurozone bonds at the widest in a generation. Although the flow of net QE purchases is set to end, the stock of ECB QE holdings will continue to support Eurozone bonds. And importantly, low yields in the Euro area are anchored by the ECB’s negative deposit rate. We do not expect the deposit rate to rise until underlying inflation shows more convincing signs of picking up. That might be evident by the middle of next year, but the risks are to a later start to the ECB’s tightening cycle, especially in the light of softening Eurozone growth and the resurgence of political risk in Italy. All that points to the yield pick up from switching out of Eurozone bonds into global bonds remaining quite wide.
An important qualification here is that for many institutional investors in particular, the currency-hedged yield pickup from foreign bonds is more important than the headline spread. As US short yields have increased, and the curve has flattened relentlessly, US bonds have become less attractive to currency-hedged investors, and Eurozone bonds more so. Both these measures of yield pickup are important, but empirically, European cross-border bond flows have been more closely related to the headline spread than the currency-hedged spread [see Chart 4].
All told, it seems reasonable to expect, at the least, considerably reduced outflows from European bonds, as the ECB moves away from QE. But low yields in Europe will continue to exert a drag on global bond yields until a more convincing upturn in inflation triggers the start of an ECB hiking cycle.