Coming Out of COVID-19: A Look at Interest Rates and Inflation in Europe

The challenges of COVID-19 and a prolonged low-interest-rate environment have caused many investors to question their fixed income allocations. From a European perspective, we still see plenty of potential opportunities in the year ahead and beyond.

The Inflation Factor

Inflation is certainly on the minds of many investors, given what looks to be a stronger year of growth in many economies amid a continued recovery from the pandemic. We have seen US Treasury yields rise amid the threat of reflation, and bond yields in Europe have followed suit.

Our view is that interest rates are not going up in Europe to any meaningful degree this year. While it seems likely we will see a move higher in inflation in the United States, a lot of it could be transitory and confined to certain sectors. Whereas in Europe, in our view, the chances of having durable inflation remain incredibly low.

The rate of consumer price inflation for the euro area was 0.9% year-on-year in January 2021, rebounding after several months of negative readings. The European Central Bank (ECB) has forecast eurozone inflation to rise to 1.3% by 2023, but it has been overshooting for years. While inflation could move a bit higher from current levels, it doesn’t mean it will be something severe enough to spook the bond market or cause the ECB to change its policy course.

The reality is the recovery from COVID-19 will take several years in Europe to get back to pre-pandemic levels. In this type of environment, we think the ECB is going to remain very accommodative and is likely to continue its asset purchasing program, which has flooded the market with liquidity. Given the likelihood of a slow recovery, we don’t see interest rates rising in the euro area for at least five years. Remember, it took Europe over a decade to get back to where it was before the global financial crisis of 2008-2009.