European Front‑End Markets: Valuation Strikes Back

This year will turn out to be an important inflection point for investors in European short-term markets. The European Central Bank (ECB) has not only ended net asset purchases, but is also aiming to bring policy rates back into positive territory. At its July meeting, the ECB increased rates by 50 basis points (bps) – a somewhat surprising turn of events given that this speed of policy normalization was unlikely at the beginning of the year. The July increase was also larger than the rate hike signaled at the ECB’s June meeting, and it finally concludes an eight-year period of negative policy rates. As per current ECB guidance, the policy rate will likely turn positive in September, with further rate hikes to come.

Inflationary pressures as a result of the pandemic and the war in Ukraine have led to a sharp and sudden repricing of the European rates universe, with the ECB currently priced for a 175-bp hiking cycle (which translates into a terminal rate of 1.25% in the deposit facility rate), as shown in Figure 1. We believe that current market pricing finally offers much more reasonable compensation to European front-end investors compared with what has been on offer during most of the last decade. That said, we would not place too much emphasis on various estimates of a neutral policy rate for the euro area; for example, the terminal rate of the current hiking cycle might well end up in restrictive policy territory instead of the broadly neutral 1.25%.

Figure 1: European forward rates have shot upImage Pop Up

We also believe that the ECB, once it has left negative policy rates behind, will be rather reluctant to re-embark on such a policy measure in the future. Negative policy rates since 2014 were largely an effort to steer clear of sovereign bond purchases for as long as possible, given the elevated political sensitivities around large-scale quantitative easing at the time. Going forward, if a disinflationary environment were to warrant additional accommodation at the zero lower interest rate bound, we believe the ECB would be more likely to resort to broad-based asset purchases, forward guidance, and favorable refinancing operations for the banking sector – without negative rates being part of the monetary policy mix again.

From defense to select offense

While we believe that now may be a good time to deploy capital in European short-term markets, we see two risks that are important for investment decisions over the medium term – risks that argue for a move to select offense, while not entirely abandoning the theme of defense. Volatility ahead (the first risk) speaks to a focus on active management, while the prospect of recession (the second risk) argues for a focus on quality.