LONDON (Reuters) - Investors cheered a key step toward fiscal integration in the European Union via a new recovery fund agreed on Tuesday, seeing it as a turning point for the region’s financial assets plagued for years by debt crises and a north-south divide.
The 750-billion-euro ($864.68 billion) fund had been hailed as a game changer and unprecedented act of solidarity in almost seven decades of European convergence. The move helped the single currency hit one-and-a-half-year highs.
For years, threats like Greece’s debt crisis and a eurosceptic populist government in Italy had stirred fear among investors that the end could be near for the euro zone.
So it was no surprise that the euro and Italian government bonds - assets that have taken a beating whenever those threats flared up - shined on hopes of European fiscal integration.
“This deal removed almost completely the risk of a European break-up, which has always been on the mind of investors,” said Ugo Lancioni, head of global currency at Neuberger Berman.
Investors say the landmark deal to rescue EU economies from the coronavirus crisis bodes well for the euro and the bloc’s equities, while Italy’s soaring debt levels could cap further gains in Italian government bonds (BTPs).
“One of the reasons you would have been sceptical of the long-term value of the euro has been diminished,” said Quentin Fitzsimmons, portfolio manager at T. Rowe Price, which manages $1 trillion. Fitzsimmons has been building a long position in the euro over the last six weeks.
BTPs have returned 6% since the recovery package was first proposed in May, and Tuesday’s breakthrough deal sent borrowing costs in Italy to their lowest since March, wiping much of the coronavirus sell-off.
Those gains led some money managers to pocket profits over the last few weeks while others were gunning to make more.
Newton Investment Management’s Paul Brain is happy to hold onto his overweight position, expecting the closely watched risk premium Italy pays for 10-year debt on top of Germany to fall to around 90 basis points from roughly 160 bps now.
Despite the new fund, others continued to see the rising debt pile from the crisis as a concern.
“Ultimately you shouldn’t go all in just because of the recovery fund,” said Andrea Iannelli, investment director at Fidelity International, who took profits from BTPs over the last two weeks.
The fund is unlikely to have a major impact on Italy’s debt mountain as the net benefit it will receive pales next to the explosion awaiting its debt-to-GDP ratio, which could rise to 159% of GDP, from 134.8% in 2019.
That prospect led Kevin Zhao, head of global sovereign fixed income at UBS Asset Management, to cut his position in BTPs around a month ago. He’s not thinking of adding back, seeing little prospect for a further rally.
“If the economy is still weak, you don’t want to earn just a little carry without due consideration to future tail risks or shocks,” he said, referring to a trade where investors use cheap funds to buy higher-yielding assets like Italian government bonds.
Expectations are rosier for stocks and the euro.
Morgan Stanley said it expected euro zone equities to outperform global peers by 10%, mainly led by Italy and Spain.
For the euro, investors said they chose not to overstretch their long positions this week, but added that steps toward fiscal integration strengthen the long-term case for the euro, boosting its appeal as a reserve currency.
That means the euro will tick more boxes when investors find new reasons to upsize their positions. One such situation is already brewing.
“On the other side of the Atlantic, you still have a tricky, messy political situation and the absence of any coherent response to COVID-19,” said Vasileios Gkionakis, global head of FX strategy at Lombard Odier, already overweight the euro.
“It’s really a perfect storm for the (U.S.) dollar and quite a strong tailwind for the euro.”
Reporting by Yoruk Bahceli, Olga Cotaga, Elizabeth Howcroft; editing by Thyagaraju Adinarayan and Mark Heinrich