Hopeless inconsistencies

On Friday, after the market close, rating agency S&P left Italy’s rating unchanged at BBB with a negative outlook. So let me think, Italy was on a negative outlook, the world has locked down due to the coronavirus, Italy has committed to spending even more money that it doesn’t have, and the rating is unchanged and still on negative outlook? 

So what did the agency give as reasons for the unchanged rating?

They said that Italy is an open and diversified economy with low levels of private debt. Well yes, but that hasn’t changed in any way during this crisis, so how can this be a counterpoint to the increase in government debt to an estimated 153% of GDP? Well I’ll tell you how – because the ECB are going to buy it. The review hints on numerous occasions that the ECB is Italy’s “backstop” to be able to finance its debt pile at real interest rates of “around 0%”.

They go on to say that Italy has private debt levels lower than Germany at 110% vs 114%. Is that a good thing? Italians have a high propensity to save, so is this not a symptom of low investment, not a counter balance to the high levels of government debt? I wonder if they are going to give the Germans a ticking off for their elevated levels of private debt relative to Italy when they do their next review?

Where did they admit they could be wrong?

If the debt path fails to improve over the next three years then S&P noted that they could lower the rating. They assume an end-of-2020 debt to GDP of 153% and deficit of 6.3%, where on Friday the Italian government produced estimates of 155% and 10.4%, so they are already behind the curve on the day they have released the review. 

What about Greece?

S&P also reviewed Greece on Friday, downgrading the outlook to stable from positive due to the fallout from the coronavirus pandemic. Does it seem to anyone else that there is some inconsistency here? Or is it just the fact that Greece is already junk and Italy is sensitively close to the sub-investment grade rating? 

I will let you decide for yourself if there is a smell of Italian sardines here, but not to worry, the ECB is at the dining table. 

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How long can Italy cling on to its investment grade rating?

With the coronavirus having spread throughout Italy, and with the country’s already worrying debt profile, how will the ratings agencies view the sovereign that is hovering perilously close to junk status? 

GDP growth in Italy has been broadly on a falling trajectory since the start of 2018, with growth falling into negative territory at the end of 2019. The manufacturing and services sectors followed the overall Eurozone picture of decline throughout the past two years, with signs of stabilisation more recently. Italy however, is obviously different to the average Eurozone market regarding the debt position, which is currently north of 135% of GDP. This level, while high on a relative basis, is more acute in Italy than other indebted nations like Greece or Portugal, given the level of yield spread that the government must pay to refinance, along with the large nominal amount of debt. Having said that, the debt profile is elongated enough such that the requirement to refinance is drawn out over a long period.

Much of the volatility in Italy in the past few years has been broadly a function of politics. It has been an evolving theme of populist, nationalist and socialist agendas involving a mixture of regional and national political parties. Generally, the widening of spreads is related to the success of the Lega and Five Star parties, which have sought to battle the EU for more expansionary fiscal policy than is acceptable under the stability and growth pact. More recently however, the tension has been reduced, as the vote of no confidence called by the Salvini-led Lega backfired and left them out of a new ruling coalition. As such, budget tensions are reduced for now and the danger for the Lega is that the conversation has now moved on.

So with the coronavirus worsening the fiscal position, how likely is it that we will see a downgrade to junk?

The issue with the Eurozone fiscal response is that Italy can’t afford it, despite the ECB pouring over €1 trillion worth of QE into Eurozone bond markets this year. The current government is more fiscally sensible than in the past and it is also aware that the market will punish it if it tries to push through irresponsible spending plans, however the macro data will be significantly hit by the virus. The government has also announced significant fiscal and liquidity measures in line with other Eurozone governments. The pandemic fiscal package will be waived under the stability and growth pact rules, but that doesn’t mean that Italy can afford it with debt to GDP of 135%. To be clear, debt sustainability is not the issue, with the term structure they have – it’s more of a market confidence issue. 

On the plus side, the ECB’s Pandemic Emergency Purchase Programme (PEPP) package is significant, and affords the ECB the ability to support member countries as its sees fit, without worrying about breaching individual-country exposure limits. Furthermore, the ECB has been explicit within the PEPP programme (and through its external commentary) that they will not allow an isolated blow-out in Italy to potentially infect the wider Eurozone.

The ECB stimulus has been announced and is significant, but should now be broadly in the price. In the short term, the rating review by S&P on 24 April is a flash point (S&P already have a BBB rating / negative outlook, and Moody’s review follows on 8 May). Over the medium term, the overwhelming driver will be the horrific growth and debt trajectory. It seems increasingly likely that the ratings agencies will decide to downgrade the sovereign.

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Government bonds: the new normal?

Government bond markets used to be conventional. Macroeconomics departments at prestigious universities all taught the ancient (given the short history of economics) orthodoxy of GDP, inflation, current account balances and unemployment all determining government bond yields. But the old truths have stopped working lately.

Take steadily rising employment across the Eurozone since 2013 – did this spur inflation and drive bond yields upwards? No…

How about a decade of rising US consumer confidence – has this driven 10-year Treasury yields to 5%? Try 1.7%….

Times have changed, and so too have the variables that affect bond yields. The textbooks of 20 years ago simply don’t work in today’s world of quantitative easing, negative interest rates and trade wars. Instead, we can see the new determinants of government yields recently have been market inflation expectations (5y5y inflation swaps), market expectations of central bank rates, forward guidance from the Fed, and the positioning of hedge funds.

So let’s assume that today’s relationships hold – an imperfect assumption I agree, but recent history is a better predictor of the near future than things that drove markets 50 years ago. How should we position a government bond portfolio through to the end of the year?

Inflation expectations have collapsed, rate expectations in the US and Europe – and globally – are for more rate cuts this year and into 2020, and Fed communication on rates has been shifting downwards all year. I think in this environment you own bonds. That’s the medium term trade where inflation is going nowhere and central banks are going to buy assets for a very long time.

In terms of value, bond investors often look at carry – in other words, the return you get from holding the bond and assuming that rates don’t go anywhere. But carry is not a very good indicator of the return from holding a bond over your investment horizon. Italian bonds may be good “carry” at 1.4% over the German equivalent, but you are going be looking at a big hole in your fund performance if you buy them today and they blow out to 3% tomorrow. A much better indicator of the attractiveness of an investment is not the carry, but the carry adjusted for the volatility of the asset. Volatility adjusted carry (VAC) has been proven over certain time periods to be significant in producing an excess return.

Looking at VAC, in my chart below, 5-year Greece is the most attractive government bond asset to own. I like the improving credit story and overarching ECB support. So from here I stay long Greece – maybe I’ll sell when the ECB wants to buy them from me.

Source: Bloomberg


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The ECB sheds more light on the September Meeting

On Monday, the ECB’s Chief Economist Philip Lane gave a speech. Given the timing, so soon after the September policy meeting, it was no doubt crafted as an opportunity for the ECB to clarify its message in light of the market reaction. It is the Governing Council’s chance to either validate or correct the market’s response to the new policy measures.

In the conclusion, he said “Forward guidance on the key ECB policy rates is a very powerful instrument and remains our principal tool, together with the level of our key policy rates, for adjusting the monetary policy stance.” This speech was attempting to clarify the ECB’s position even further, to stop markets from swinging their expectations wildly ahead of each policy meeting.

There were two sections to the speech: the economic environment; and the ECB’s monetary policy response to it in the September meeting. The first was nothing new – trade disruption is weakening the global economy, the manufacturing sector is slowing but services and the labour market have not yet been hit.

The second section, on the ECB’s response, had a number of significant points:

  • Inflation target: “a clarification of our reaction function: our determination to act when inflation falls short of our medium-term inflation aim is just as strong as our determination to act when inflation exceeds that aim.

This appears to be a response to those who suggest that the ECB would allow inflation to “run hot” to compensate for the lengthy period of sub-target inflation we currently inhabit.

  • Negative rates: “Negative rates have supported the portfolio rebalancing channel of the asset purchase programme (APP) by encouraging banks to lend to the broad economy instead of holding onto liquidity.”

This is a re-emphasis that the ECB views negative interest rates as an effective tool, and that they have a positive impact on bank lending – perhaps in response to those that ask whether negative interest rates are actually hindering, not helping.

  • Further rate cuts: “We judge that, if needed, we can further lower the deposit facility rate and, with it, the overnight money market rate. As a result, there is no reason for the distribution of future short-term rate expectations to be skewed upwards.”

This is fairly self-explanatory, but confirms to the market that they won’t be seeing any upward surprises in the near future, and the effective lower bound is not here yet.

  • QE: “we are confident that the envisaged purchase volumes will be consistent with the current parameters of the APP for an extended period of time.”

We have on this very blog questioned whether the €20bn Asset Purchase Program figure is a realistic upper bound, and the ECB is responding (though perhaps not specifically to us) that they don’t expect QE to exceed this level. The ECB thinks they have time and headroom, but that will run out within six to nine months.

  • Forward Guidance: “The phrase “robustly converge” means that the Governing Council wants to be sure that the process of convergence is sufficiently mature and realistic before starting to lift policy rates. The qualification that convergence needs to be “consistently reflected in underlying inflation dynamics” means that the trajectory of realised inflation should underpin our inflation outlook.”

This is, in my opinion, the key point. He says that before policy rates can rise, and before QE can again be wound down, not only do inflation expectations have to rise, but realised inflation needs to follow those expectations. This stresses that the ECB needs to see actual, sustained inflation growth before rates will rise again – reducing fears of over-tightening killing any nascent recovery.

So if you’re looking for the potential pain trade from here, taking this speech into account, it would be where the trade tariffs cause more harm to the industrial sector and the weakness spills into services and the labour market. Underlying inflation stays depressed, and the ECB cuts rates further and lifts the ISIN limits on government purchases.

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How will the Swiss react to the ECB

The Swiss National Bank meeting this week will be more closely watched by markets than usual. Typically there is little drama stemming from the safe-haven alpine nation. But with inflation threatening to fall through zero, an appreciating currency and the ECB having just cut interest rates, the SNB faces a challenge to keep the economy on track.

The question this week is, how can the SNB use the policy options it has in its toolbox to try and slow the currency appreciation, which is weighing on exports and growth? In my view it’s likely that they will change their characterisation of the currency from “highly valued” to “overvalued”, which will help put a brake on the FX market, at least for a while.

Then there is the question of a rate cut. On the one hand, inflation is falling, growth is weak and the currency is rising. On the other, the inflationary forces at work are external, imported from the ECBs recent rate cut. The SNB could choose to cut rates further into negative territory, from the current -0.75% level. A token 10bp rate cut would keep up with the ECB, but would have little effect on the real economy – it’s just not as effective a tool to manage the currency as direct FX market intervention. However, a larger-than-expected rate cut of 25bps would send a strong signal that the SNB will resist the external pressure. This is not the market’s base case, and would be a surprise.

With the spread between the ECB deposit rate and the SNB target rate now wider than before the ECB meeting, if the SNB does not cut, they will need to communicate why and questions will be asked about their reaction function should we see further rate cuts from the ECB.

We can look at the interest rate expectations derived from the yield curve to see what the market is currently pricing. As you can see below, the market expects rates to be 9bps lower by October and trough at 18bps lower from today’s level of -0.75% in February next year.

Source: Bloomberg

You could argue that the fact that the ECB only cut rates by 10bps, and not more as some expected, takes some pressure off the SNB to cut. But holding steady is going to disappoint the market and likely cause further appreciation in the Franc, further stifling the Swiss economy.

Post-meeting update, 19/09/19:

At the policy meeting on the 18th September, the Swiss National Bank left rates unchanged, and reiterated that they are “willing to intervene in the foreign exchange market as necessary”. Following the ECB rate cut last week, the interest rate differential is now wider than it was and the FX and bond markets took the announcement as a disappointment. The market was expecting a cut of around 10bps, so the decision to hold saw front end yields rise and the currency strengthen. The statement stuck with the language that the currency is “highly valued”, which given the limited amount of appreciation since the last meeting, is fair enough. But the whole picture here is important, not just the currency. With inflation hovering above zero and the SNB’s projections signalling only limited pick-up to 0.2% next year, I think that this policy stance needs to shift in the future. This fits with the view that the ECB needs to cut rates further into negative territory, something I have made a case for in the past, and a natural follow on from the tiered rate policy they have just introduced. So for now we have to await the next meeting on the 12th December to see if the SNB will capitulate and cut rates further. A lot can happen between now and then.

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[VIDEO] A Red Herring: Our view on the ECB announcement

Mario Draghi’s penultimate policy meeting yesterday brought a rate cut, the return of QE, and some assistance to Europe’s beleaguered banking sector. But will it have the intended effect of stimulating the Eurozone? Watch now to see our take on the ECB policy changes.


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ECB Meeting – Steady As She Goes

The ECB left rates and the asset purchase target unchanged at their September monetary policy meeting.

The meeting was accompanied by the ECB staff macroeconomic projections, which showed a marginal reduction in the growth forecast versus the projections released in June. Real GDP growth in 2018 was lowered to 2% from 2.1%, in 2019 to 1.8% from 1.9% and in 2020 left unchanged at 1.7%. The risks to this forecast remain “broadly balanced” as communicated in previous policy meetings.

On the inflation front, the headline Harmonised Index of Consumer Prices (HICP) forecast was left unchanged at 1.7% until the end of 2020. Underlying this was weak oil prices being offset by “significantly stronger” core inflation driven by rising wages.

There was no discussion on reinvestment of the asset purchase programme redemptions, with Draghi suggesting that the likely date for this would be October or December.

The worries in Italy, Argentina and Turkey were, in Draghi’s view, reflective of weak fundamentals and as such contagion has been limited, with Italy viewed as an “Italian episode”.

Rates markets rallied however this is more likely reflective of the lower than forecast inflation number out of the US, released at the same time as the press conference.

All in all, no material information and we continue on the ECB glide path.

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LIBOR, it’s all coming to a dramatic end!

You need an interesting title when writing about a topic that tends to have people nodding off after the first sentence. So what is the deal with this LIBOR thingy then?

LIBOR – the London Inter-bank Offered Rate – is going down the drain, thanks to the traders who decided to make up the rate for the next day’s cost of overnight money at dinner one night. We always knew that the Libor fix was a bit dodgy in some of the less transparent overseas markets. That’s why some interest rate swaps trade versus the very liquid USD floating rate and not the domestic floating interest rate (think Russia and Turkey). But for a more established market such as the UK, the scandal was a bit of a shock, though probably a good thing in the long term given that the changes being introduced will make the rate materially more robust and trustworthy.

I have written about the story before, but it’s worth updating a few points.

Firstly, the US Federal Reserve has begun publishing its new overnight reference rate in the US – SOFR, or the Secured Overnight Financing Rate. This is a little different to the UK SONIA rate (Sterling Overnight Index Average rate) as the US SOFR is based on secured transactions as opposed to SONIA’s unsecured rate. (Typically a secured funding rate is lower as the lender receives security against government bonds).

Going forward, the Chicago Mercantile Exchange (CME) is going to launch futures contracts on the new rate, adding to the existing EuroDollar futures market. Later this year, clearing will start for SOFR swaps. So while we are a long way off replacing the LIBOR swap market in the US, it’s the direction of travel.

Over here in the UK, the SONIA fixing is getting a fancy new haircut and shiny new trainers: it’s going to be “reformed”, with more breadth of transactions and a slightly different averaging calculation. So we get a nice trustworthy benchmark, administered by the Bank of England, which we can all transition to from the market’s LIBOR legacy book.

Think about that last line a minute: “that we can all transition to from the market’s LIBOR legacy book”. Who has a legacy book?

Investors using a liability-driven investment strategy (LDI) have a legacy book. Many practitioners in LDI swap their long-dated cash flows (think 30, 40, 50 years) using LIBOR. The market will need to replace LIBOR when it is finally retired (date to be determined). So we have seen a pickup in new hedging being done in SONIA as opposed to LIBOR. This can be seen in the spread between the LIBOR and SONIA rates, which has moved noticeably as shown in Chart 1 below.

Chart 1: 30-year LIBOR – SONIA swap spread

Source: Bloomberg.

How does this affect a pension mandate then?

Most schemes using swaps are ‘in the money’, as those that have ‘received fixed’ from an older, higher interest rate environment now have a paper profit.

In all of these in-the-money swaps, there is a risk of the current discount curve (SONIA) moving differently to the forward curve (Libor) – so the market needs to pay close attention to SONIA moves relative to LIBOR. Guess what? That’s happening now!

How far this relationship goes and the implications for numerous pension schemes is unclear, but what is certain is that it’s a regime change, so expect a bit of a ride.


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A Liborious task ahead

Yesterday the CEO of the FCA, Andrew Bailey, gave a speech in which he supported ending the publication of LIBOR (London Inter-Bank Offer Rate), the key risk-free reference rate used by the financial system in the UK. In general the comments were nothing new – this has been a project in progress by the Bank of England for many years – so why did the market pay so much attention to the comments? Well, the intent implied in Bailey’s speech was more than the market expected, as well as there being a specific time frame mentioned: 2021.

What is the problem with LIBOR?

There are two main issues with using LIBOR as a reference for risk-free interest rates. Firstly, the most common LIBOR rate used is the 6-month LIBOR (the rate at which banks will lend cash on an unsecured basis in the interbank market for a term of 6 months). The fact that this rate is for a 6-month loan implies that it is not actually a risk-free rate – it carries a 6-month term premium. The second main issue is the way that the LIBOR rate is set, as it relies on banks to submit an estimate of where they think they can lend money. As it is not based on actual traded transactions, it is subject to gaming – as was seen in the well-publicised LIBOR scandal. To solve these issues, the Bank of England working group on sterling risk-free rates proposed in April that SONIA should replace LIBOR and be administered by the Bank of England.

What is SONIA?

The Sterling OverNight Index Average (SONIA) is a reference rate that is based on actual transactions in the overnight unsecured loan and deposit market. Reformed SONIA will actually replace SONIA shortly; reformed SONIA includes other market participants outside the interbank broker market and therefore has a much higher transactional volume than current SONIA.

What would the change mean for the derivatives market?

Currently LIBOR is used as the reference rate for the majority of interest rate derivatives held by end users and used to hedge a variety of liabilities, bonds, loans and other financial instruments. As a result the LIBOR swap market is the most liquid and cost effective hedge, as well as being a match for existing legacy LIBOR derivative positions held by end users. There is also a liquid market in SONIA swaps, however liquidity falls once the maturity of the trade becomes longer than 5 years.

The SONIA swap market has existed for around 10 years, so why have market participants not voluntarily migrated to SONIA? This is a legacy issue. The market agrees that if we were to design the market again from scratch, LIBOR would not be the main reference rate. But with so much of the market already using the fix, it’s not easy to wean off it! The market needs a regulatory push, the FCA and BOE do not see LIBOR as a desirable reference rate, and the comments yesterday are the next step in this process.

Much of the current derivatives trading is facilitated by the large and liquid pool of short sterling futures contracts. For the market to adopt a new reference rate such as SONIA, there needs to be a successful SONIA futures market established, something which is currently being consulted on by the Bank of England working group. Another issue that needs to be resolved is the ability to centrally clear SONIA swaps with maturity longer than 30 years, which is the current maximum – again a focus for the working group.

Clearly the FCA and BOE are intent on moving the market away from LIBOR over the long term. The working group has the (big) job of consulting on this transition and are seeking input from all market participants. There are undoubtedly challenges ahead – but change can be a good thing. This is a global theme with similar projects happening in the US and elsewhere, with the collective ambition of benefiting all market participants.

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