With the recent election of Emmanuel Macron as French president, “Europe has voted for the status quo”, says Hugh Hendry of Eclectica Asset Management. That means the euro is unlikely to break up, which in turn means “asset prices in Germany and other core countries have to move higher to compensate for the lower risk”. There is already evidence of “a bubble… emerging in German equity prices”. However, the Bundesbank (Germany’s central bank) “will simply not tolerate” this. So there will be plenty of pressure on the European Central Bank (ECB) “to normalise interest rates”.
This presents European policymakers with a dilemma. On the one hand, their “understandable” measures to end the recession have caused bubbles “in both the corporate and sovereign bond sectors”. On the other, with Italian elections due next year, the ECB also needs to keep rates low enough “to keep Italy in the system” by allowing its economy to grow. Yet, says Hendry, raising eurozone rates from today’s negative levels may well be good for Europe – banks will be far more willing to lend (because they wouldn’t end up effectively paying the lender). So ECB governor Mario Draghi might “be able to have his cake and eat it”, by raising rates to zero: “an optical tightening, but also an effective stimulus”.
As a result, Hendry reckons yields on high-quality European sovereign bonds will rise. True, betting on German bond prices falling could “end up being a widowmaker” trade (like shorting Japanese bonds), but overall, he’s confident that. At the very least, he “increasingly questions the idea of negative rates persisting”.