Considering the Eurozone’s humble rate of recovery, interest rates in the area will likely remain very low for a prolonged period of time. This outlook is strengthened by European sovereign bond markets in the area. Sovereign yields have fallen to all-time lows. The benchmark German ten-year bond yield has fallen to close on 1% from just below 2% at the start of the year.
European yields at an all-time low
Mario Draghi, president of the European Central Bank (or ECB) and former Goldman Sachs (GS) managing director, unveiled a suite of stimulus measures on Thursday, June 5 at the ECB’s policy meeting. Initially, bond yields fell. Yields on short and long-term debt in the Eurozone also fell.
The measures were directed to foster the Eurozone recovery and stem deflation. They boosted the single currency’s economic prospects and future inflation expectations.
Mario Draghi cut the main interest rates to record low levels. The key re-financing rate was reduced from 0.25% to 0.15%. The deposit rate moved into negative territory. It had been reduced from zero to 0.1%.
What does the negative interest rate imply?
As a result, the ECB became the first major central bank to have a negative interest rate on its deposits. This means that the ECB would charge lenders to park cash reserves at the central bank. The move encourages banks to lend cash in order to stimulate investment and growth. Holding excess cash as reserves would now be costly for the banks.
What led to the rally?
The rally for European bonds was initially fueled by the belief that the country is less likely to default on its debts. Recently, the bonds have been attractive. Investors have wanted relatively high-yielding investments—U.S. Treasuries yields are a safer destination because they’re way below the Eurozone. This indicates that the ECB would pump money into the financial system to spur growth soon.
Investors are convinced that the ECB will back bonds in the troubled economies, bringing them closer to a par with German debt. Investor expectations have caused yields to drop in these regions. For example, after the ECB announced a new round of easing measures, most European bonds dropped in yield relative to Treasuries, which have actually been rising lately.
Among the peripheral Eurozone nations, Greece has some of the highest government bond yields. There’s a lot more credit risk in Greece. The Greek ten-year bond yields are as high as 6.61%. With improving fundamentals, Spain’s bond yields essentially reflect near zero risk because the economy enjoys a better credit rating than all other PIIGS (or Portugal, Ireland, Italy, Greece, and Spain) nations. On Monday, June 9, the yield on the ten-year government bond in Spain had actually dropped below the ten-year U.S. Treasury note for the first time since 2010.
The impact of Mario Draghi’s negative interest rate decision on the capital markets in these countries can be assessed by looking at the performance of popular exchange-traded funds (or ETFs) like the iShares MSCI Italy Capped ETF (EWI) and the iShares MSCI Spain Capped (EWP). These ETFs track the broad stock market performance in these specific countries. ETFs like the Vanguard FTSE Europe ETF (VGK) and the iShares MSCI EMU Index (EZU) track the broad stock market performance in Europe in general.
Let’s take a look at each of the peripheral Eurozone nations to understand the current prevailing economics. In the next parts of the series, we’ll assess whether investors should include the countries in their portfolio.