9 July 2015

The Greek debt crisis has entered a critical phase after the country voted a resounding ‘no’ to austerity in its referendum on financing terms. European leaders and the European Central Bank need to gauge carefully the economic, humanitarian and political cost of their options from here, although the onus falls on Greece to push for an acceptable deal. The country urgently needs money to keep its economy afloat (ATMs are expected to run out of cash within days) and meet sizeable obligations to the official sector over the next two weeks. Despite headlines warning of contagion risks, I believe eurozone bonds remain attractive.

An eerie calm

The initial market reaction to the surprise announcement of the referendum and the unexpectedly firm rejection by the Greek people of the financing proposals has been surprisingly muted. Even peripheral bond yields – a key gauge of any potential contagion from the crisis – have to date shown relatively little stress. The yields on the 10-year bonds of Spain and Italy rose by 24–26bps from 26 June (before the Greek government announced the referendum) to 6 July, the day after the referendum. The yield on Portugal’s 10-year bond rose by 47bps although even that move falls short of the violent sell-off many had feared given the outcome of the poll.

Peripheral bonds sold off more aggressively in the period of sharp volatility that hit global bond markets from late April, when benchmark 10-year Spanish and Italian government bond yields rose 115bps and 109bps, respectively, from mid-April to mid-June. The yield on the 10-year Portuguese government bond rose 155bps over the same period. Improved growth prospects and a receding fear of deflation undoubtedly contributed to these moves, although the scale of the sell-off suggests it had more to do with technical market factors than fundamentals changing.1

Still positive on eurozone bonds

The outlook remains positive for eurozone bonds. Issuance has been front-loaded so far this year to take advantage of low borrowing rates created by European Central Bank (ECB) bond-buying. However, this is expected to switch into negative net issuance as we move into the summer, which will support markets. Furthermore, whereas the US and UK labour markets have regained their pre-crisis levels, Europe at its current pace is likely to require another six years of healing to return to pre-crisis levels.

Our expectation that monetary policy divergence will increase as the year progresses further supports our positive view of eurozone bonds. We expect the US Federal Reserve will start raising interest rates later this year or early in 2016, with the Bank of England following suit shortly thereafter. In contrast, we expect the ECB (and Bank of Japan) to maintain their aggressive asset purchase programmes.

Spread widening since April against the supportive backdrop has created opportunities in eurozone sovereign bonds. We particularly favour the sovereign debt of Portugal and Slovenia, which offer strengthening fundamentals (recovering growth and relative competitiveness) and attractive valuations relative to core bonds. Further spread widening from any Greek crisis fallout could offer further chances to build positions.

1 Bloomberg, July 2015

CARS ref: RSM-1504
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 08 July 2015 and may change as subsequent conditions vary.

Whereas the US and UK labour markets have regained their pre-crisis levels, Europe at its current pace is likely to require another six years of healing to return to pre-crisis levels.