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Negative yields on eurozone debt may fall further with QE still to come

The rally in euro area sovereign debt may have further to run even after yields across the single currency bloc fell below zero as investors have only partially priced in a resumption of the European Central Bank's quantitative easing program.

Yields on German 10-year debt fell to a record low of -0.40% on July 4, while the rate on equivalent-maturity French, Dutch, Austria and Belgium bonds have all been in negative territory in July with Dutch notes negatively yielding since May 31. Even yields on debt from so-called peripheral eurozone nations has fallen below zero: Italian two-year securities were yielding -0.05% on July 3, while the much maligned Greek 10-debt was yielding a record-low 2.76% on July 3, having been 5% at the start of the year.

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Euro-region government bond yields have evaporated as ECB President Mario Draghi signaled that he will push the benchmark rate further below zero, while comments from ECB Chief Economist Philip Lane and Netherlands central bank President Klaas Knot hinted that extraordinary monetary policy measures could be deployed.

Draghi went so far as saying in a June 18 speech that the ECB is now looking for any reason that "could prevent the ECB from cutting rates.”

The synchronized rally in the eurozone's bond markets is "a clear sign the market is beginning to price QE," even without any firm indication that it will happen and when, Bank of America Merrill Lynch FX Strategist Athanasios Vamvakidis wrote in an emailed note.

Italian signals

The particularly strong performance of Italian bonds — yields on Italian 10-year BTPs fell from 2.31% from June 14 to 1.63% on July 3 — shows that investors are attracted to assets that are perceived to benefit most from a fresh round of QE, he said.

While the Federal Reserve entered a cycle of rate increases in December 2016, the eurozone economy has remained on life support. The ECB's deposit rate has been at negative 0.4% since March 2016, and it has over €2.1 trillion of sovereign bonds on its balance sheet from its first round of QE that ran from March 2015 to December 2018. Its third round of cheap loans to banks, known as TLTRO III, will start in September and end in March 2021.

"We now think that the ECB’s next move will be to cut its deposit rate by 10 basis points to -0.5% in September and have brought forward our forecast for the bank’s next round of quantitative easing to November 2019, from mid-2020 previously," said Simona Gambarini, markets economist at Capital Economics.

The performance of German bunds relative to other perceived safe havens is evidence the market is pricing in looser monetary policy from the ECB. The bund yield fell 15 basis points between Draghi's June 18 speech and the July 4 low, while yields on other safe havens, such as the U.S., Japan and Switzerland, shed 10 basis points, 3 basis points and 11 basis points, respectively.

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Stocks rally

Stocks have also rallied as investors look for returns outside the bond market — yields do not turn positive on German government debt until maturities of 20 years or longer. Italy's FTSE MIB gained 10.5% between June 1 and July 9, hitting a new 12-month high as increasingly dovish ECB policies are expected to particularly benefit the fragile Italian economy and financial sector. Germany's DAX rose 6%, while France's CAC 40 climbed 7%.

Italy's political climate has been relatively sedate recently amid a more passive tone from its populist coalition government, but a fresh clash with the European Union over Italy's 2020 budget in the autumn is likely, ING Groep analysts led by Senior Rates Strategist Benjamin Schroeder, wrote in a research note. "Levels below 200 bps look hardly sustainable beyond the medium term."

Italy is subject to a debt sustainability monitor with the European Commission under which it is expected to actively reduce its public debt, which the OECD predicts will hit 133.8% this year, the second-largest in the euro area behind Greece. Both partners of Italy's coalition government have expensive policy plans and want room to stretch public finances further, potentially setting the scene for a repeat of the escalation in anti-EU rhetoric that saw yields on Italian debt soar in 2018.

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"This, on top of slowing economic growth, is limiting the potential for price gains on equities noticeably," said Jens Wilhelm, a portfolio manager at Union Investment. "We are favoring Greek and Spanish government bonds, as government debt is coming down in both countries."

Currency fallout

Side effects of the ECB's aggressive policies include lower returns for banks, which have struggled compared with their U.S. counterparts as monetary policy has diverged.

As well as pumping up the bond market, the ECB's policies have depressed the value of the euro, earning a number of rebukes from Donald Trump, raising fears that Europe will become the next target of the U.S. president's trade war.

The euro was trading at $1.12 as of 8:43 a.m. ET, down 1.7% from Jan. 1. However, the dollar's relative strength may be coming to an end, according to Martin Enlund, global chief FX strategist at Nordea Bank.

The end of the Federal Reserve's quantitative tightening could see the dollar weaken in the third quarter as the excess of liquidity stops shrinking, he said. "At roughly the same time, the ECB’s new TLTROs have looked unlikely to prevent excess liquidity of euros from shrinking. This would have made for a diverging liquidity outlook — more dollars, fewer euros — and, if supply & demand matters, a higher EUR/USD."