Central banks have responded quickly to the more downbeat outlook, striking an accommodative tone. The sovereign bond market overreacted, decorrelating from other asset classes. However, this over-bearishness, coupled with fiscal stimulus in Europe and signs that world trade is stabilising, has prepared the ground for upside surprises on Europe’s economy. Watch for the pendulum swinging back.
- The US Federal Reserve changes tone
- Weak eurozone inflation set to last?
- The fundamentals don’t explain such low long bond yields
Monetary policy: is the Fed tearing up the rulebook while the ECB shrugs its shoulders?
US monetary policy and long US bond yields
The US Federal Reserve (Fed) clearly indicated a change in monetary policy during the first quarter. Members of the Federal Open Markets Committee no longer anticipate any rate hikes in 2019 (according to the dot plot). A view markets markets have been signalling for weeks.
The Fed seems to be continuing its switch from inflation targeting to price-level targeting via a medium-term inflation target. Under this approach it should allow inflation to exceed 2% without reacting drastically, given the prolonged period during which inflation has remained below target over recent years.
Fewer rate hikes can be expected in this cycle, but long bond yields should factor in a higher inflation term premium. The market is pricing in less policy tightening but still fears a slump in US growth.
The 3-month/10-year curve actually inverted after statements by Stephen Moore (nominated for the Fed’s governing board) advocating an immediate 50 basis point cut. But even if this Trump-friendly candidate is appointed he will only be one voice and decisions are taken not by majority but by consensus. So, while 2-year yields should remain low, 10-year yields could move back toward 2.75% in the medium term if we see a slight rebound in US economic indicators.
Eurozone monetary policy
The ECB surprised the market at its meeting on 7 March. A new TLTRO (targeted longer-term refinancing operations) programme had been widely anticipated but not so soon.
Forward guidance is now for no rate changes before the end of the year. Fears of a contraction in lending growth to non-financial firms could have be an explanation for these announcements but it also seems the ECB is resigned to inflation remaining below its 2% target over the long term. Its 2021 forecast was for inflation of only 1.6% while the market had got used to more wishful forecasts closer to target (often between 1.8% and 1.9%).
Market reaction was prompt. Market expectations for 5-year inflation 5 years forward have fallen back to the lows of 2016. These levels drew a rapid response from several ECB members, including President Draghi, floating the idea of a two-tiered deposit rate. This would allow the ECB to keep rates negative longer while limiting the impact on commercial banks. Negative rates are costing eurozone banks (mainly German, French and Dutch) around EUR 7-8 billion annually.
Long euro yields and the yield curve
Weak German growth data, ECB announcements and the easing of US rates have pushed the German 10-year rate into negative territory (-0.08%). Short and medium-term (5-year) maturities are effectively protected by the extension of forward guidance, new TLTROs and the possibility of creating two deposit rates. However, the ECB is a long way from restarting its debt purchase programme.
European yields seemed to be living on another planet throughout the first quarter, defying classical negative correlations with risky assets (equities or corporate bond spreads). We do not believe that this trend is sustainable in the medium term. While growth is unquestionably lacklustre, it could rebound slightly and in our view does not justify current price levels for sovereign debt.
Exhibit 1: Yields of 10-year German sovereign debt returned to negative territory during the first quarter of 2019
Source: BNP Paribas Asset Management, Bloomberg, as of 16/04/19
We initially expect German 10-year yields to return to 0.20%-0.30%. Subsequently, they should trade between 0.20% and 0.60% over the next few quarters.
Brexit could obviously upset these forecasts, which is why, in a context of cheap volatility; we have been buying calls on German sovereign debt futures. This gives us a hedge against extreme events such as a no-deal Brexit.
Southern European countries
Following its agreement with the European Commission, Italy enjoyed a few weeks of respite, notably thanks to the success of its initial auctions. Fitch & Moody’s have left their ratings unchanged and if S&P follows suit on 26 April it could dampen down Italian yields’ volatility for weeks to come.
Nonetheless, the long-term outlook for economic growth in Italy has deteriorated with growth stuck close to 0% in 2019, resulting in a deficit that will breach the targets of 2.04%.
The outcome of European elections will be critical as a strong showing by the right-wing coalition could lead to expectations of early general elections.
Spain should continue to benefit from the scarcity of AAA/AA assets. A one-notch improvement in Spain’s credit rating by Moody’s (from Baa1 to A3) would anchor Spain firmly among the “safe” sovereigns for the market, but this cannot happen before 24 May. Spanish yields offer an attractive premium to the meagre returns being paid by AA countries.
Irish yields are vulnerable to volatility due to fears of a no-deal Brexit and we prefer to underweight the country as the spread over AA countries is unattractive.
Fundamentals are still positive for investment-grade-rated companies in Europe (no increase in net debt, for example) with many more upgrades than downgrades over the past 12 months (10% more, a 20-year record).
Following major outflows from pure credit funds in 2018, flows stabilised in January and turned positive in February and March. Investors started the year with plenty of cash to invest, whereas traders had no stocks. The primary market was dynamic for non-financial companies, but bank issues, while higher than in first quarter, were still lower than expected. This backdrop led to a marked tightening in credit spreads, which nonetheless held above their long-term median. However, the long end of the curve looks expensive as do synthetic indices.
Corporate bonds from non-financial issuers
In the eurozone, while companies’ borrowings are still generally high (particularly in France), net debt of the biggest investment-grade companies (rated BBB- or above) remains limited. Default risk on the investment-grade bond market therefore remains low. Primary issue spreads are closing in on the secondary market as order books have filled up. Values are less attractive than at the end of last year. We are therefore taking a cautious line on the long end, although the short end should be protected by an extension of the TLTRO programme. We seized on some attractive tender offers to reduce our hybrid debt positions in non-financial corporates.
Corporate bonds from financial issuers
Banks have geared back up, thanks mainly to regulations and the introduction of the leverage ratio and TLAC. Despite this, LT2 (lower tier 2) spreads remain more attractive than spreads on non-financial corporate debt. Banks now have a new liquidity safety net in the form of the ECB’s newly announced TLTROs. However, we remain highly selective on bank quality. We prefer LT2 paper from the best banks over senior debt of their lower-quality peers. As for senior non-preferred debt, which has been expensive until recently, the heavy issuance needed to meet TLAC requirements has pushed banks to offer attractive premiums on the primary market. Moreover, rating upgrades for bank issuers are becoming increasingly frequent.
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