Interest Rates Are Rising and PIIGS Will Fly

There are few places to hide for investors when interest rates and inflation are rising. Government bonds, which are usually a good diversifier during a market downturn, have collapsed in almost equal measure to equities this year leading many analysts to refer to the current environment as the “everywhere risk”.
 
During the business cycle of 2010 – 2020, the average annual market return on the S&P index was about 14%. With inflation at 2%, investor’s real return was 12%. Today, however, with inflation at over 8% and share values correcting across all indices, investor returns are in free fall. The S&P and Nasdaq are down over 20%  compared to this time a year ago.

​As inflation rises, central banks raise short term interest rates to dampen demand. As rates rise, bond prices fall as investors opt for higher yielding bonds. The rout in bond markets has left fixed income investors 11% worse off this year following $2.5 trillion in drawdowns.  
 
While the ECB’s short term deposit rate will increase this year in increments of just 25 basis points (a quarter of a percent), the knock-on effects to long duration bonds have far reaching consequences. The yield on the benchmark 10 year Irish treasury has almost doubled from 0.17% to 2.03% over the past 12 months. Borrowing costs for the Irish government are now twice as expensive than this time last year.
 
Rising government bond yields push up mortgage rates too as banks now factor in higher risk free rates associated with lending to the state, plus bank margins. Standard variable rates could rise as high as 4%-5% next year if the ECB continue to raise rates. Business lending could become prohibitively high too given some Irish banks charge a margin of 5%. That could push rates up to 8%-9% next year for many businesses unless the ECB intervene.
 
In Italy, the Eurozone’s third largest economy, government borrowing costs have trebled over the past 12 months. The yield on the 10 year Italian bond is now over 4%, its highest level since 2014. In 2012 during the height of the Eurozone debt crisis, the yield on a 10 year Italian bond was 6%. The yield on Greek debt reached a whopping 30%. Unable to service their debts, Portugal, Italy, Ireland, Greece and Spain, the so-called PIIGS of Europe, were forced into restructuring programmes. Years of austerity followed and the Euro flirted with collapse.
 
In response, the EU’s “do whatever it takes” approach led to massive quantitative easing programmes (QE) that allowed its central bank, the ECB, to directly monetize EU sovereign debt. These large bond purchasing programmes drove up the price of bonds and pushed yields lower. Interest rates in Europe fell close to zero percent which allowed debt strapped countries to slowly begin re-building their economies. 
 
Given sovereign debt is now even higher than a decade ago, however, the ECB faces a very difficult trade-off between inflation and presiding over another debt crisis. Pivoting so early in its tightening cycle won’t be popular among inflation hawks but the ECB could be forced nonetheless to restart large QE programmes to keep a lid on rising yields. The spread (difference) between German and Italian 10 year bond yields is now 2.25%, over 100 basis points higher than the start of 2022.
 
By careful yield curve control the ECB can still raise short term rates while pushing down the cost of long term sovereign debt via bond purchasing. It's likely this is what the ECB will be forced into doing. Even in the face of high inflation the EU will not risk fragmentation or spreads from widening much further between rich and poorer member states. As the lender of last resort, the ECB will act as a backstop to bond investors effectively guaranteeing a risk-free environment for high yields. Investors who get ahead of the market could benefit enormously from rising bond prices.
 
Interest rate futures are betting on short term rates in the Eurozone to reach 1% by the end of 2023. Although still extremely accommodating at that level, Italian yields could rise to 4% or 5% before the ECB intervenes. It might pay for investors to lock in these higher yielding assets at low cost over a short 2-5 period in the meantime. When QE eventually kicks in there would be no shortage of demand for higher yielding bonds when newly issued bond yields fall.
 
With slowing global growth and a bear market for equities likely to continue this year and beyond, owning higher yielding EU government debt could prove to be the trade of the next few years. PIIGS will fly after all.