Euro bonds may be best bet during US-China currency war

When the dollar fights the yuan, the real winner may be the euro.

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    Currency market tensions are fueling demand for safer assets [Miguel Angel Sanchez/Bloomberg]
    Currency market tensions are fueling demand for safer assets [Miguel Angel Sanchez/Bloomberg]

    The growing threat of a global currency war is spurring the unprecedented European bond rally in more ways than one.

    While trade tensions are already sparking a flight of capital into of the region's safest assets, an escalation of the situation could see a rival emerge for the European Central Bank as a major buyer of euro-area debt - the Swiss National Bank.

    While the U.S.-China trade spat has fueled worldwide market turmoil, it has had the opposite effect on the Swiss franc, an investor haven. The currency's rally to a two-year high is threatening the SNB's goal to spur inflation and may see the central bank intervene to rein in the exchange rate - by buying euros - and then investing in the region's bonds, according to Commerzbank AG.

    Benchmark German yields have slumped to a record low of -0.55% this week after the U.S. formally labeled China a currency manipulator, in response to the People's Bank of China’s move to weaken the yuan to levels unseen since 2008. The SNB may have already started intervening - the central bank's sight deposits, which economists consider an early indicator of its currency-market activity, jumped last week in the second consecutive sizable increase.

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    "The latest foreign-exchange developments could mean the SNB will need to intervene, which means the ECB will be in competition in its demand for European bonds," said Christoph Rieger, head of fixed-rate strategy at Commerzbank. If the Swiss central bank starts buying, "you can pick any number" as to how low yields may go, he said.

    Should the SNB start actively buying debt, it could find itself vying with the ECB to hoover up the region's sovereign bonds. The euro-area central bank is widely expected to announce in September that it is adding to its 2.6 trillion euro ($2.9 trillion) stockpile of debt in an effort to bring inflation back toward its close-to, but below 2% target.

    "It adds yet another buyer to the European government bond complex," said James Athey, a money manager at Aberdeen Standard Investments, who has a long position in 30-year German bonds. "So in spite of how negative they are I don't see any let-up" in the debt rally, he said.

    Swiss 'firepower'

    The threat of a full-blown currency war has risen as central banks are already shifting back into easing mode, with the Federal Reserve cutting interest rates last week and the ECB hinting at its own stimulus measures.

    The prospect of the Swiss central bank entering the market means Europe's bond rally may still have room to run, according to Allianz Global Investors. The entire German curve now yields less than zero - turning on its head the idea that investors get paid to loan out money - while yields in France and Spain have also dropped to record lows.

    "The SNB absolutely has the firepower to cause big moves in European government bonds," said Mike Riddell, a money manager at Allianz. "Bond yields can go significantly lower everywhere if the SNB is doing this."

    SOURCE: Bloomberg