Early interest rate increase in Europe a worry for investors

Asset owners and money managers in Europe are entering 2018 with a key risk in mind: an interest rate hike that could come from the European Central Bank earlier than expected.

Making the potential for a rate hike even more acute is the expected reinvestment of proceeds from matured bonds, set to begin in the second quarter, that are held by the ECB under its asset purchase program. About €130 billion ($154 billion) could be reinvested in European markets from these proceeds in the six months between March 31 and Sept. 30, sources said. Market participants see these planned reinvestments as a way to smooth the effects of monetary policy normalization as the ECB continues to try to meet its inflation target.

Some institutional investors think the ECB, which this month is expected to begin scaling back its monthly asset purchases to €30 billion from €60 billion, will stop net bond purchases altogether at the end of September.

In preparation, some European investors are taking short positions on U.S. Treasuries in their portfolios, anticipating that U.S. Treasuries will fall as interest rates increase. Others are focusing on adding inflation protection.

"In preparation for a rate increase we have been short 10-year U.S. Treasuries," said Olivier Rousseau, executive director at the €36 billion Fonds de Reserve pour les Retraites in Paris. "I don't think we are unique in this approach. We also expect a January effect. Rates could move upwards as early as in January."

German asset owners are being careful about developments in rates as the changes will put pressure on the whole portfolio, said Dijana Pantic, portfolio manager, fixed income, at Union Investment Institutional in Frankfurt. Union Investment, she said, is short 10-year U.S. Treasuries.

Italian institutional investors also are mapping out the path they will take in the event of an ECB rate hike.

Diego Ballarin at the €527 million Fondo Pensione Prevedi in Rome, in an email, said: "I expect the interest rate will grow in a very slow and progressive way in 2018."

As quantitative easing is due to decline during the course of the year, asset owners recognize the need to prepare portfolios against the prospect of more volatility in the economy.

"At the moment, 10% of our portfolio is invested in inflation-linked bonds (however) this share could grow significantly if market conditions will require it," Mr. Ballarin said.

Still, some money managers are waiting for further signals from the ECB before making any tactical decisions. "Any significant change in QE policy will be priced by the market pretty much immediately," said David Lloyd, Twickenham, England-based head of institutional fund management at M&G Investments.

"We do not seek to predict these events and preposition portfolios accordingly. Rather, we will wait for the market's reaction, and assess the opportunities that these moves may create." M&G had £179 billion ($232 billion) in fixed-income assets as of June 30, 2017.

However, the ECB is expected to reinvest proceeds in combination with the remaining bond purchases at a pace near €40 billion per month, alleviating the pressure, which may prompt investors to act.

"With total reinvestments of around €124 billion, the yield curve steepening will not be as big as anticipated," Ms. Pantic said. "But we are being careful on duration and we expect some steepening of the yield curve."

The scaling back of the central bank's asset purchases also means eurozone bonds will become increasingly available to other investors in Europe. French, Portuguese, Italian and Dutch bonds are expected to increase in terms of supply as the ECB halves asset purchases to €30 billion this quarter before the reinvestments kick in at the end of March.

Ms. Pantic said Union Investments is positive on assets such as Portuguese and Italian bonds, which offer the most yield. She added there "could be additional pressure on Italy due to elections in March, so we are more positive on Spain and Portugal." Union Investments had €162.5 billion in fixed-income assets under management and €320 billion in total assets at the end of September.

One undesirable impact of the ECB's tapering later in the year might be that the central bank misses its inflation target of close to 2%. Sources said the ECB's policy of slowing its quantitative easing program toward September will contribute to more volatile market conditions and could hurt investors who bought riskier assets for returns. In the event of a rate hike, market participants will not be prepared to take on more risk.

"Moving further away from its inflation target is problematic for risky assets. It is also not positive for equity," said Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers in London.

And while the ECB is set to reduce its sovereign bond asset purchases, some money managers said the bank might remain a net asset purchaser of corporate bonds, buying up to €45 billion this year. By comparison the ECB bought some €80 billion in 2017.

With the prospect of the ECB staying in the market beyond September, money managers said they prefer to focus on assets whose prices are not affected by the bank's policy.

"We continue to favor European financials as they are not eligible for ECB purchases," said David Riley, head of credit strategy at BlueBay Asset Management in London.