ANALYSIS-After wild year, euro zone is top pick of world bond markets

Credit: REUTERS/Ralph Orlowski

By Yoruk Bahceli

Dec 19 (Reuters) - For investors who braved their 'bonds are back' call in a turbulent year, euro zone debt was the big winner and a souring economy with tighter purse strings mean its allure will continue in 2024.

The euro zone government bond market, worth roughly $10-trillion, is set to return 6.5% this year, leading a rebound from two years of negative global bond returns as inflation soared.

The market has sharply outperformed U.S. Treasuries, up 3.5% this year, and UK gilts, up 2.4%, according to ICE BofA indexes.

Italian bonds, at the epicentre of worries around the impact of record-paced interest rate hikes, returned nearly 9%.

For some, that's just the beginning.

"We are now taking most of our really big bullish bond views via Europe, because that's where the growth picture is really so weak," said Mike Riddell, senior portfolio manager at Allianz Global Investors, who has shifted out of the United States and Canada into Europe.

Inflation in the euro zone is easing fast and a year-end recession looms. The bloc is tipped to grow just 0.6% next year, half the rate of the United States, according to Reuters polling, boosting the case for safe-haven German bonds.

A 60-billion-euro blow to Germany's budget by its constitutional court could crimp next year's growth by up to 0.5%, as Berlin cuts spending to return to a 'debt brake' limiting new borrowing.

TIGHTER FISCAL POLICY

Chris Jeffery, head of rates and inflation strategy at Legal and General Investment Management, said the German court ruling supported his decision to favour European bonds over U.S. Treasuries.

"It's going to be tighter fiscal policy that's big enough to be macro relevant," he said, noting German spending cuts come just as euro zone finance ministers try to reform their fiscal rules for member states that seek to limit deficits.

Another advantage: unlike the United States, none of the bloc's big economies hold elections next year, removing a potential source of additional spending pressure in a year of high funding needs with central banks continuing to run down their balance sheets.

Euro funding needs are also high, yet the new debt left for investors to take on after European Central Bank buying is more similar to this year, while investors will need to adjust to sharply higher U.S. debt issuance, BofA notes.

Thursday's ECB decision to phase out reinvestments of bonds under its pandemic scheme by end-2024, rather than halting them earlier, has added to bullish sentiment.

That plan "is more gradual than expected and should be manageable, also because the ECB will retain its option to use reinvestments in a flexible way throughout next year," said Frederik Ducrozet, Pictet Wealth Management's head of macroeconomic research.

HOLD ON

But there are risks.

First, high volatility. Year-end gains follow some wild price swings with bonds hit hard in February and September. The top three quarters for European daily bond trading volumes since 2014 all came this year, the Association for Financial Markets in Europe said on Monday.

Debt agency chiefs say hedge funds are helping fill the void left by the ECB.

In addition, a stellar year-end rally means German bond yields, which move inversely with prices, have dropped to levels where some banks forecast they would be at end-2024, so further falls could be limited.

And Italy may lose its shine, especially if renew scrutiny of its finances. Kal El-Wahab, head of EMEA linear rates trading at BofA, expects euro zone outperformance to focus on Germany, with high funding needs likely to weigh on Italy.

Any signs of waning demand from retail investors, key to taking down Italy's funding this year, could also weigh on its debt, Barclays warns.

GILT TRIP?

Yet inflation, anathema to bond investors, remains a bigger challenge, with a Reuters poll expecting it to be 3% next year, compared to 2.5% in the euro zone and 2.6% in the U.S.

UK funding needs, the second highest on record for the next financial year, are also seen as more challenging.

"We've seen a lack of demand from the LDI community all year, which is one of the reasons why (UK) bonds have underperformed," BofA's El-Wahab said, referring to the liability-driven investors investing for pension funds at the centre of last year's "mini budget" crisis.

Craig Inches, head of rates and cash at Royal London Asset Management, said he was more worried about high issuance in the UK, where he holds a 'neutral' position, compared to the U.S., with dwindling pension fund appetite making him "nervous".

Euro zone debt big 'bonds are back' winner in 2023 https://tmsnrt.rs/47ZMeEw

Euro zone government bond yields ending 2023 lower https://tmsnrt.rs/3tlJK44

(Reporting by Yoruk Bahceli; editing by Dhara Ranasinghe and Christina Fincher)

((Yoruk.Bahceli@thomsonreuters.com; +44 20 7542 7571; Reuters Messaging: yoruk.bahceli@thomsonreuters.com))

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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