The Week: Time to move in or out of European fixed income?

The ECB may have raised rates, but bond yields are still falling. Investors are voting with their feet on European fixed income. Are they right?

  • The ECB raised rates by a surprise 0.5% in mid-July
  • Fixed income funds saw EUR 28.4bn of net outflows in June, capping the worst half-year ever
  • Yields could move lower from here, but there are still many uncertainties

Last week saw the ECB raise rates for the first time in 11 years as European policymakers sought to tackle chronic inflation pressures. The rise of 0.5% was higher than analysts had expected and follows a pattern of aggressive rate hikes across the globe. The ECB also committed to a further 0.5% rate hike in September. 

On the face of it, it seems perfectly rational to ship out of fixed income at this point. Rising rates have generally been bad news for fixed income markets and there is little potential easing of inflationary pressures. This is exactly what investors have done. According the latest Morningstar statistics, fixed income funds saw EUR 28.4bn of net outflows in June. This capped the worst half-year on record for bond funds, with EUR 84bn leaving the sector. 

In contrast – and in spite of the recent volatility in equity markets – only EUR 12.1bn has moved out of equity funds. Passive equity funds have been experiencing positive monthly flows since May 2020. 

However, even though the ECB’s rate rise was higher than expected by economists, it appears to have been largely priced into the market. Bond yields have been slipping since mid-June and have continued to fall even after the recent rate rise. The German 10 year bond yield, for example, reached a peak of almost 1.8% in June and is now just 0.9%. Italian 10 year yields have moved from 4.2% to 3.3%. 

Have investors moved out of European fixed income at just the wrong moment? It is easy to paint a relatively gloomy picture about the Eurozone economy. Germany in particular, the region’s powerhouse, faces an uncertain outlook given its reliance on Russian energy. Recent research from the IMF suggests that the impact of the Ukrainian war could shave as much as 1.5% from German GDP growth in the short-term. 

This economic weakness is pushing yields lower and may continue to do so in the short-term. The ECB faces an even trickier balancing act than many of its peers in tackling inflation without collapsing the economy. Nevertheless, it is unlikely to change its aggressive stance until it sees inflation starting to ebb. 

European investors’ reluctance to re-embrace fixed income is understandable. Yes, yields have been dropping, but there is still significant uncertainty. There are no guarantees that the ECB will change its stance even if the economic situation gets very difficult.