Europe’s Interest Rate Cut Is Carving Out Opportunities

• As expected, the ECB started cutting rates in June.

• This creates opportunities for diligent bond investors, offering both the prospect of income and capital gains.

• The key is to stay vigilant and watch for changes in the data.

The big picture in Europe looks a bit different for investors this week. And that’s because last week, the European Central Bank (ECB) officially began chipping away at the region’s record-high lending rates. It’s a big deal: the pivot from interest rate hikes to cuts should have a serious impact on bonds across the bloc – and create some attractive opportunities.

So is this the end of an era?

It does feel a bit that way. The move marks a definite finale to the ECB’s fastest and steepest series of interest rate hikes ever – a run that left its benchmark deposit lending rate at an all-time high of 4%. It also marks a turning point for its bond market: historically, interest rate cuts support bond performance, driving prices higher and yields lower.

Bond prices and yields behave like a seesaw: when yields fall, prices rise. Since 1999, the Bloomberg Euro Aggregate Index has returned over 5% on average in the 12 months following ECB rate reductions. That includes a nice distribution too, as the top 75th percentile of return periods was over 8%, and the bottom 25th percentile return was around 2%.

The fundamental outlook for European bonds is based on three key drivers: growth, inflation, and ECB interest rate decisions.

On the economic growth front, the European scene is pretty muted. Despite signs of improvement, the economy is likely to grow by less than 1% this year, more sluggishly than its recent, seven-year average. But there are still pockets of strength: for example, earnings trends have been stable, so there are no real worries that companies will default on their debt.

And inflation has become less of a worry, with the annual core measure (which excludes the more volatile food and energy prices) rising by just 2.9% in May of this year, versus 5.3% in May of 2023. Now, some will point out that May’s numbers were slightly higher than economists expected, but there were always going to be bumps along the way. And the fact is that Europe is far from declaring victory. Inflation isn’t falling quite as fast now as it was back in 2023. And that – combined with still-strong wage inflation and a low starting point for energy prices – is likely to keep the overall inflation figure well above the ECB’s 2% target, at least for the rest of this year.

So what does that mean for interest rates?

Well, when it comes to bringing inflation down, high interest rates really are the best tool a central bank’s got. When rates are high, folks and businesses tend to borrow less and spend less – and that dampens the outlook for potential consumer price gains.

Now, the policymakers at the ECB have said they’re going to keep a close eye on economic data and will want to see inflation in the services sector slip below 3.5% in the second half of the year (from 4.1% in May). This would bring prices back in line with the Bank’s forecasts and justify its desire to make two more interest rate cuts this year.

To cut any more than that, the ECB would need to see inflation drop below its 2% target – which seems highly unlikely, especially if the US central bank continues to keep its interest rates high. See, higher interest rates can increase the value of a country’s currency relative to its rivals, because higher rates make a currency more attractive to international savers and investors. So, with the ECB lowering its rates and the US Federal Reserve (the Fed) holding its rates steady, the greenback is likely to make gains against the euro. And that will eventually increase the price of goods imported to Europe – which is just another inflationary force for the ECB to contend with.

That said, investors increasingly expect the Fed to take a go-slow approach when it does begin lowering its interest rates. And there could be some investing opportunities here, as divergences increase with different growth, inflation, and policy paths in Europe and elsewhere.

Where are the opportunities then?

Shorter-dated investment-grade corporate and government bonds look particularly appealing. High starting yields mean those investments can deliver strong total returns in most scenarios. Shorter-maturity bonds are likely to benefit from interest rate cuts, as the yield curve typically steepens following rate cuts. This results in shorter-maturity bond yields decreasing more than their longer-maturity counterparts, which is good for bond returns.

In the credit market, European investment-grade corporate bonds present good value over the medium to long term. These assets have historically performed well in the 12 months following a central bank pause, as investors seek credit assets with attractive yields. All-in yields are attractive, with highly rated corporate bond yields offering a premium of 0.5 percentage points above the Stoxx Europe 600 Equity index dividend yield.

Credit spreads in investment-grades assets can no longer be characterized as “cheap”, given the rally over the past year. However, European spreads are still cheap compared to the US dollar market – at least based on their historical relationships. And the spreads in Europe have probably not fully priced out the risk premium established from Russia’s ongoing war in Ukraine and the energy concerns stemming from that.

The best segment within credit might be short-dated corporate bonds with maturities of one to five years. If government bond yields remain relatively unchanged, investors can benefit from an additional 0.9 percentage points in yield. And if yields fall, these assets will generate strong returns. If growth weakens and spreads widen, the decrease in government bond yields should offset most, if not all, capital losses. This will ultimately lead to positive returns when considering the starting yield.

High-yield debt, on the other hand, offers relatively little added premium considering the risk it comes with, and that should probably leave you feeling somewhat cautious. The situation reflects some very favorable technical dynamics. Investors have been cautiously sitting on high cash balances, and there have been few new bonds issued, but plenty of upgrades to investment grade (including Ford). As a result, the size of the euro high-yield market has shrunk by 15% over the past two years. And that’s weighed on its yields.