Since QE3 ended last October, clients have looked for the source of the next rally and many believe it is to be found in Europe.

Initially, the European Central Bank's own QE program met expectations as yields in Germany, France, Italy and Spain fell precipitously. But concerns about Greece quickly erased those gains.

Clients, already frustrated with very low yield at home, will need to be persuaded they should look to Europe, which seems especially risky with Greece on the knife's edge and just recently removed from a bizarre state of negative yields. (The German five-year bond at the end of the first quarter had a yield of -0.14%.)  Yet there will be buyers in the market.

If your client is left asking, "Why accept such unfair terms?" there are several rational explanations: Index funds have to buy paper regardless of yield and volatility; speculators may be betting on currency appreciation; and arbitrageurs are also looking for opportunities.


Deflation fear, however, may be the most likely justification. After all, the whole reason that the ECB is buying bonds by the bucketful is to lift a foundering economy that has a GDP growth rate of a measly 0.9% and an inflation rate of  -0.1%.

Compared with stateside investors, the willingness of European individuals to tolerate low- to negative-yielding bonds has already been well established, as is their familiarity with bond ownership.

According to the Association for Financial Markets in Europe, investors in Italy own at least 20% of direct bond investment and Germans own 10% to 15%; in the U.S., the figure is closer to 7% as bond fund ownership is a decidedly more popular route to fixed- income investment. In other words, U.S. investors aren't stepping into a market that European investors are afraid of.


This sets up a difficult scenario for American investors: the best chance at a bond rally is within a group of countries with even-lower interest rates, within a union that may lose a member, and against a falling currency (the euro) that provides a stiff headwind for dollar investors. But simple supply and demand may be on their side.

That massive bond-buying scheme by the ECB can't buy up everything. By mandate, the central bank can't buy bonds that yield less than -0.2%, which thankfully are bunched up at the short end of the yield curve. That leaves long-duration paper available for now.

It also can't buy that which isn't available; according to analysts at Bank of America, the German government (never a big fan of anything inflationary) plans to run a budget surplus this year that will allow it to retire some bonds and reduce the issuance of others. Without one of the eurozone's biggest and most secure borrowers, investors will gravitate to peripheral countries like Spain and Italy, where 10-year bonds yield around 1.47%.

Slightly farther down the risk scale, Portuguese government bonds yield 2%. It may not be comfortable to invest at the long end and/or in the periphery, but knowing the ECB juggernaut is also limited should soothe those fears.


While the conversation is still centered on deflation and how far indicators need to go before inflation targets are reached, the wild card remains oil prices. Should they recover, their impact on inflation data would change the calculus to continue the ECB's bond buying and speculative demand could abruptly end and send yields higher.

Furthermore, policy tightening in the U.S. (and possibly England) would make Uncle Sam's debt look even more attractive and pull down investor sentiment for European bonds.

So far, that sentiment is pretty strong as measured by fund flows data. Through the start of the quarter, investors in mutual funds and ETFs had added an estimated $3.9 billion to funds in Lipper's International Income Funds group, which means that 2014's record of $4.5 billion is easily within reach.

Recent experience shows that central bankers will do, in the famous words of Mario Draghi, "whatever it takes" to promote economic stability and growth.

With subzero deposit rates still available across the continent, playing it safe is perhaps more expensive than ever before. Many savers will get steamrolled by central bankers who are eager to prime the engine of growth, despite the distortions it has already produced.

High-quality investment grade peripheral debt and high-yield issues from the center were among the first beneficiaries of the ECB's QE. After the Greek drama plays out (odds are still just one-in-four of an EU exit), bond investors may again be pushed out of their comfort zone down the credit scale and farther along the yield curve.

It might seem like a risky gambit to trust ECB policymakers, who may be as busy fighting internecine politics as they are deflation, but their influence is very real and their checkbook quite large.

Jeff Tjornehoj is head of research for Lipper in the U.S., Canada and Latin America. Follow him on Twitter at @JeffTjornehoj.

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