Three Developments in Europe You May Have Missed over the Summer-and One You Didn't

The months of July and August are traditionally a little quieter for markets in Europe as participants take a summer break. But things don’t stop completely. As the wheels get back up to speed, David Zahn, Franklin Templeton’s Head of European Fixed Income, considers a few developments in Europe over the summer months that might have slipped under the radar.

“Flight to Quality” Pushes Core European Bond Yields to Unrealistic Levels

For a few days in the traditionally quiet mid-August period, concerns about a crisis in Turkey generated feverish headlines and created some volatility in emerging-market assets.

We felt the likely economic fallout was largely confined to Turkey and we regard the knock-on effect on the financial markets and economies of the European Union as very small.

One or two individual European banks had some exposure to the Turkish lira, but these were generally considered to have more than enough capital to deal with any problem. So, the risk of contagion to the European financial sector seems to us negligible.

Investors Adopt Risk-Off Approach

However, noise around the situation in Turkey did trigger a risk-off sentiment among some investors, prompting a so-called “flight to quality”.

Investors’ risk aversion has driven yields in core European bonds down over the past few months. Notably, the 10-year German bund tumbled to 0.30% in mid-August.

Ultra-low German bond yields don’t make sense to us, when you consider the macroeconomic background in the eurozone: core inflation is still near 1%, with headline inflation at around 2%.

The European Central Bank’s (ECB’s) asset-buying program looks set to wrap up at the end of the year, which we think should keep a cap on European bond yields. However, we’d expect to see the German 10-year yield up at around 0.70% to 0.80% at least, which would still reflect some risk premium built in.

Bank of Japan’s Stealth Taper

One of the potentially most interesting developments for European bond markets over the summer happened well away from Europe—in Japan.

While it appears the ECB will start wrapping up its quantitative easing (QE) program at the end of this year, the Bank of Japan (BOJ) will likely be the last major central bank still engaged in asset purchases.

But slowly and without fanfare, even the BOJ has been reducing its purchases over time in what we refer to as a “stealth taper.”