8th December 2016

Nervous markets expect

MARKET CLOSE:
FTSE 100
6,902, 122
DAX
10,987, +211
S&P 500
x,xxx, +-xx
iTraxx Main
74bp, -0.5bp
iTraxx X-Over Index
315.5bp, -0.5bp
10 Yr Bund
0.34%, -3bp
iBoxx Corp IG
B+137.4bp, -0.5bp 
iBoxx Corp HY Index
B+434bp, -7bp
10 Yr US T-Bond
2.34%, -4.5bp

Better be safe than sorry…

banca-monte-dei-paschi

Bailout expected: The Italian bank is the world’s oldest lender

Going into the ECB meeting, the markets were cock-a-hoop about something. There were risk-asset/safe-haven rallies all around. Why the sudden extended optimism in stocks which also saw government bonds rally? The former was likely derived from the potential for a bail-out for Monte dei Paschi (according to reports) and the latter from rising expectations that the ECB will extend QE. That announcement is expected today.

In addition there is a back-link for both to any Monte bailout vis-a-vis Italy sovereign debt entering the ECB’s Outright Monetary Transaction mechanism which is designed to help member states in financial difficulty. We all know that Italy is…

To us, the QE extension was just an excuse for bonds to rally. There has been nothing in the current data crop to give us new, or fresh impetus that they would extend QE – we always believed they would. Still, extending QE in the Eurozone completely diverges with US policy. It keeps rates low here for longer and the “pull impact” of rising US Treasury yields promoting higher yields in Europe will start to wane – unless we see evidence of sustained higher economic growth and inflation in the Eurozone.

We’re not ready for higher rates yet and should start to think about the historical relationship between US policy/rates/growth/equities and those in Europe. We will not necessarily be 6-9 months behind. For instance, UK industrial production for October recorded a surprise 1.3% drop versus the month before – and for the third consecutive month, sterling weakened on the back of the report and equities rose. After a period of brighter news, this now comes as a real warning that the BoE needs to continue to push along with current policy while the UK needs a dose of fiscal profligacy a la US (to come). We have to think that similar negative surprises from various economic measures will be forthcoming across the Eurozone in due course.

Corporate bond market outlook uncertain

For the corporate bond market, spreads were better which one could reasonably have expected to be the case, but there is an air of uneasiness as we look toward 2017. This year looks like seeing out total returns of 4% for IG and 6%+ for HY. Sterling corporate credit will top the lot, with returns somewhere in the order of 9-10%.

But 2017 will not be about improving or stable corporate credit quality. Nor will it be about where the default rate might drift to (that is, stay around these very low levels). The levels of issuance will be taken down in their usual manner with some tweaking around final price versus initial guidance. Macro overall will remain broadly supportive. Credit strategy ‘2017 style’ will be about rate markets. Get that call right and one will be top of the pile.

The last few years have been about taking the highest beta risk one’s portfolio allows. Positioning for the compression trade has been a “gimme” most of the time. Otherwise, differentiating between sectors, credit quality between borrowers and so on has been a fool’s game – or shown a lack of understanding based upon on how the ECB and other central banks have manipulated markets in order to keep them functioning. Its ensured that copious amounts of cash has poured into the corporate bond market, aided its almost exponential growth and facilitated the disintermediation trade. It’s sucked all and sundry in.

Higher rates on the back of higher growth (which will aid improvements in credit quality) and inflation will eat into total return performance. Spread benchmarked investors might rub their hands in glee at that improvement in credit metrics and tighter spreads that ought to come with it. But we’re in technical markets. And those technicals are going to work against benchmarked players too. High yield markets ought to benefit and outperform initially owing to their rate insensitive characteristics.

But credit to equity rotation – we should all have reason to fear it – when it comes.

Pre-ECB rally, early Christmas cheer

We may have rallied across the board in Wednesday’s session, but after the weakness and volatility of late, the markets remain nervous and expectant. Low rates for longer is their mantra, hence the rally in equities and in government bonds. The Monte dei Paschi potential bailout was a side issue.

The US equity rally slowed, but European stocks were having none of it. The DAX put on another near 2% and the index rose (+211 points) to the highest level for this year, approaching a heady 11,000. Any more and we will be in nose bleed territory.

Anyway, the 10-year Bund yield declined to 0.34% (-3bp) and the equivalent maturity Gilt yield to 1.35% (-6bp). The party mood saw to it that Italian BTP yields fell to 1.88% (-6bp) and Bonos at 1.42% (-7bp). It was a good day for government bond markets.

Credit wasn’t left behind although the iTraxx synthetic indices edged only slightly lower with Main at 74bp (-0.5bp) and X-Over at 315.5bp (also just 0.5bp). Cash was a little better bid and eventually left the broad measure of that product, through the index (Markit iBoxx), at B+137.4bp (-0.5bp) for IG, but HY in better shape at B+434bp (-7bp).

That’s it for today. Back tomorrow.

Suki Mann

A 25-year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on Credit Market Daily.