Money managers ready for shift on European interest rates

Money managers are preparing for possible portfolio changes if the European Central Bank's monetary policy shifts — as murmurs suggest it might — in coming months.

Amid market murmurs that the European Central Bank will move to alter the course of its monetary policy in the next few months, money managers are preparing for a number of scenarios.

In anticipation of the extension of quantitative easing beyond March 2017 at the bank's December meeting, institutional investors are convinced that rather than a conventional exit, tapering will take a different shape.

In response to yields being elevated by the taper prospect, money managers continue to try short duration or trading rates strategies, while others are moving into emerging markets from developed ones. Once the yields go up, many believe there will be an opportunity to adjust the duration of fixed-income portfolios.

“We don't prepare for a tapering event, but for markets anticipating one. So an active duration management and yield-curve positioning is well needed these days,” said Beatrice Rosenthal, senior economist at BayernInvest based in Munich.

Although the ECB did not officially extend quantitative easing at its October meeting, investors agree the perception of QE has changed. The degree of uncertainty surrounding the stimulus is now about how the taper will occur, and not only its timeline.

“The genie is out of the bottle,” said David Riley, head of credit at BlueBay Asset Management LLP, based in London.

Previously the most commonly anticipated scenario was the extension of QE beyond March. Now the possibility of an earlier exit — still vividly resonating with fixed-income managers — could also benefit a number of strategies.

One indicator of the tapering time nearing is the scarcity of eligible bonds for the ECB to purchase, which impinges on quantitative easing. The ECB is already temporarily tweaking its capital key and has stopped buying bonds yielding below the deposit rate of -0.4%.

“A substantial proportion of global bonds is trading with a negative yield, especially German bunds, so the ECB's self-imposed restriction of not buying bonds that yield below the deposit rate creates a huge scarcity of assets,” said Shweta Singh, senior global economist at Lombard Street Research in London.

Pension fund executives contacted for this article declined comment on the possibility. One U.K.-based executive said in an e-mail: “ECB said explicitly at the last meeting that tapering was not on the table.”

But some asset owners agree the scarcity of eligible bonds is key. BayernInvest's Ms. Rosenthal said the problem of bond scarcity will be addressed before ECB President Mario Draghi employs tapering. She added: “(We) expect the ECB to either scrap the capital key, buy bonds that yield less than the current deposit rate or to not stick to its proportion limits any longer.”

Pioneer Investments continues to maintain a short 10-year German bund position, which firm executives say will directly benefit from any tapering of ECB purchases once announced.

Any tapering should lead to higher yields, as investors anticipate not just a smaller monthly purchases amount, but also an eventual end to the whole bond purchase program,” said Tanguy Le Saout, head of European fixed income at Pioneer, based in London.

Matthew Rees, European investment-grade portfolio manager-active fixed income at Legal & General Investment Management in London, agreed with Mr. Le Saout. “We have seen yields move up on 10-year government bunds — from -15 to zero (to) +5 — due to the taper talk, which would allow us to alter our duration position.”

Daniel Morris, senior investment strategist at BNP Paribas Investment Partners based in London said: “Assuming the U.S. Fed will hike this December and two times next year, even if you have decent spread between Treasuries and bunds, if Treasuries yields are going up so would bunds.”

Mr. Rees believes the rise in yields is materially less than when the Federal Reserve announced its tapering in 2013.

However, there is an analogy. When the Fed said it would taper asset purchases in 2013, global bond yields and risk premiums rose sharply. By comparison, reports earlier this month that the ECB might consider tapering purchases briefly caused yields to rise.

But in 2013, the repricing of credit and U.S. Treasuries turned out to be short-lived, while emerging markets took much longer to recover.

BlueBay's Mr. Riley said emerging markets have much stronger fundamentals now. “Emerging markets spreads are better than European high yield or other asset classes.”

“We have started a rotation (in their portfolios) toward emerging markets credit from developed credit about four to five months ago,” Mr. Riley added.

Even though the ECB specifically denied an intention to taper, managers are nevertheless preparing for a shorter taper horizon.

Pioneer's managers are maintaining their credit strategy, which would benefit from tapering if the decision is made before year-end to end quantitative easing in March. “We anticipate increased volatility in credit spreads into year-end as investors may wish to protect 2016 performance with spreads close to the bottom of the range,” said Mr. Le Saout. “Any tapering of the corporate purchase program could cause a snap widening of credit spreads, which would benefit our position.”

Some managers consider yields going up an opportunity to lengthen the duration. Mr. Morris would rather shorten it. The risk is in longer-duration bonds, Mr. Morris said, potentially more so for peripheral government bonds, given that their yields have ranged more widely than those of Germany and countries on the periphery have arguably benefited the most from QE.

“This would argue for a reduction in these allocations (to both long-duration and peripheral bonds) over the medium term,” Mr. Morris said.

Paul Brain, head of fixed income at Newton Investment Management, London added: “We are not expecting the ECB to taper in December, but that being said we do not find a lot of value in euro-denominated government securities so we are defensively positioned if they do.”

Bastien Drut, fixed-income and forex strategist at Amundi, based in Paris, said it will be very hard for the ECB to stop its quantitative easing before the end of 2017: “When we take the example of the Fed's tapering (in 2013), which coincided with the appreciation of the dollar, we think if ECB was to stop its QE, the euro would appreciate significantly.”

Mr. Morris concluded: “Even if there is tapering, it will likely be a very slow and drawn out process and the ECB is likely to reinvest the proceeds as the US Treasury is doing, so there will still be monetary stimulus of some sort.”