No alarms and no surprises

In its last monetary policy meeting of the year, the European Central Bank (ECB) kept monetary policy unchanged.

There were no surprises regarding policy or signalling from the Governing Council which was very much as expected given it was only in the last meeting that the ‘recalibration’ of policy was announced.

The staff forecasts announced were a welcome Christmas present for the ECB and the Eurozone as a whole. Economic growth was revised up well above market consensus levels: in 2017 to 2.4%, 2.3% in 2018, 1.9% in 2019 and 1.7% for 2020. This is a very impressive outlook given trend growth is estimated to be around 1.5% each year.

Inflation forecasts though remain low and heavily dependent on prospective oil prices. In 2017 it is estimated to be 1.5%, 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020.

The market reaction was muted. Bond markets have become less sensitive to the growth outlook, focussing on inflation and the level of cash deposit interest rates (still negative in the Eurozone)…a situation that we believe is likely to pertain for some time to come.

Swiss National Bank

The Swiss National Bank (SNB) kept interest rates and monetary policy unchanged today.

Despite recent modest currency depreciation, the National Bank continued to reiterate that the currency remains ‘highly valued’ and thus it remains committed to maintaining its policy of negative interest rates and willingness to intervene in foreign exchange markets as necessary.

Forecasts regarding the economy were also updated. Inflation rates were revised up in 2018 and 2019 to 0.7% and 1.1% respectively. GDP is forecast to increase by 2% in 2018, compared with 1% in 2017.

We expect the SNB to maintain this policy for the foreseeable future, yet at present money market curves are priced to suggest that it will increase interest rates ahead of the European Central Bank. In our opinion this is an extremely unlikely scenario unless the Swiss franc depreciates materially.

This is something we are looking to exploit in our absolute return funds via relative value trades.

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Dull or extraordinary?

Over the years some of us fixed income fund managers have had to endure much leg pulling from our colleagues that manage assets in other more ‘exciting asset classes’. Boring, dull are adjectives I‘ve heard whispered in corridors or by the coffee machine, perhaps they weren’t talking about the asset class but I prefer not to think about that. The financial crisis quietened many down for a bit as industry professionals fell over themselves in the stampede to learn about duration, convexity, the forward forward curve and other bond jargon.   

I have defended the asset class many times over my career. I have found it an extraordinarily interesting and varied part of the financial market to work in. Where else could I combine my interest in mathematics, economics, statistics, current affairs, human behaviour, debate and discussion, all with the ambition to add value to our customers’ hard earned cash?

But …and there is a but….2017 has turned out to be somewhat boring in government bonds and this is a surprise. 2017 was supposed to be full of risks; there was Trump, there is Brexit, we have had a number of elections, some haven’t even resulted in a government yet! There was the independence vote in Catalonia and the first known flight to Brussels for refuge by Senor Puigdemont. What next? The US Federal Reserve has raised interest rates and is reducing its balance sheet. The European Central Bank has tapered and the Bank of England has raised interest rates. There has been a lot to consider.

German government bonds however have sailed serenely through these events, 10-year bonds are yielding 0.36% at the time of writing, this is also the average yield over the last 12 months, the median is 0.37% and for around 75% of the year, the yield has deviated only 0.1% from this level. Not hugely exciting although quite extraordinary when you consider it.

Very exciting when compared with Japanese bonds. In Japan the central bank operates a policy of Yield Curve Control where it targets a yield of 0% for 10-year government bonds. To do this it buys an awful lot of bonds if the yield rises too much and stops buying if it falls. And now, the market has the message and 10-year yields have traded in a mere 12 basis point (0.12%) trading range all year.  The yield today is 0.03%. Again quite extraordinary.

In the US the MOVE index which measures the volatility of the US bond market is at the lowest levels in the history of the index. Only UK gilts have tried their best to cause some angst but even so, 10-year UK debt was yielding 1.33% on the first trading day of the year. At the time of writing, 10-year gilts yield 1.30%.


The rating of your debt can go up as well as down…

Being reasonably experienced in European bonds I can just about recall the time when, just over 25 years ago, Standard & Poor’s awarded Italy its first Foreign Currency Long-Term Debt rating. Back then, Italian debt was denominated in Lira and withholding tax was payable on the coupons by investors. The gross yield on a 10-year bond was nearer 12.5%. Interestingly the post-tax differential between Italian domestic debt and German domestic debt was around 300 basis points, much higher than the 150 basis points of today. The spread however is not strictly comparable with current markets as it was in the pre-Euro period and therefore incorporated an element of currency risk. 

The credit rating awarded was AA+. Over the last 25 years, Standard & Poor’s has downgraded Italy eight times, culminating in a rating of BBB- in 2014. Yields have been volatile but currently are close to 25-year lows at around 1.75%, despite this trend of continual downgrades; the interest rate and inflation environment have had a greater influence than the credit rating.

Last Friday, the trend changed and for the first time ever, Standard & Poor’s upgraded its rating for Italian debt. Only one notch to BBB with a stable outlook. But an upgrade nonetheless.

Reasons cited were the improved economic outlook, an improvement in government finances and the resolution of some of the problems in the banking sector. Further upgrades could occur if progress is maintained, which we think is reasonably likely.

A word of caution however; we may have to wait another 25 years before a rating of AA+ is to occur.

Rates market joins the dots

On the face of it, the US Federal Reserve shouldn’t have surprised the markets last night, but by announcing their decision to keep interest rates unchanged and to start their programme to reduce their balance sheet, markets were taken aback – the USD dollar strengthened and US Treasury yields rose.    

The opening statement was bland and changes to the economic projections and the ‘dots’ were minor – which was entirely as expected. However, over the summer, questions regarding the low level of inflation and the technical difficulties of reducing the balance sheet in the face of a lack of progress in raising the debt ceiling (now pushed forward) had been raised. There had been a suspicion that the US Federal Reserve might delay or signal a shallower path of policy tightening and markets had moved accordingly. 5 year US Treasury yields had fallen around 0.15 % between June and September and the US Dollar around 5% on a trade weighted basis.

Last night the surprise was that these suspicions were proved incorrect and a reversal occurred.

What this means for the rest of the world is also of interest.  Some recovery in the US Dollar, particularly versus the Euro, may have implications for monetary policy in Europe too. A stronger US Dollar will mean there will be a lower hurdle for ECB tapering.

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Positive on the periphery

The European Central Bank’s (ECB) Governing Council decided yesterday to keep monetary policy unchanged in the euro area but signalled strongly that, all being well, policy would be ‘recalibrated’ at the October meeting. So we will all have to wait until later in the year to see the results of this meeting and whether the pace and makeup of purchases (currently spread across three programmes, the PSPP, CBPP, and the ABSPP) will change. 

Mr Draghi did rule out any change to the amount of each bond it can buy (issuer limits) and also ruled out any change to potential sequencing of its removal of accommodation – in other words, the projected path of reducing asset purchases first and then moving interest rates remains unchanged. This outcome is unlikely to come as much of a surprise to financial markets as few had been expecting any clarity at this stage in the year.

The ECB also announced its latest staff forecasts for the Eurozone economy in 2017, 2018 and 2019. Economic growth has been revised up in 2017, reflecting the current positive environment, but forecast were left unchanged for 2018 and 2019. Inflation however was revised slightly lower for 2018 and 2019, reflecting for the first time some pass-through from the strength of the euro. The revisions made were quite small so while there was some note of euro volatility in the accompanying statement, it signalled that (at this stage) the ECB is not too concerned over the external value of the euro.

We continue to expect tapering to start in 2018, and think that some change in the composition of asset purchases is likely given the ‘shortage’ of German government debt. In our view this will add to the relative attractions of peripheral European debt, already performing well as the outlook for the Eurozone economy continues to improve. As long as there is no political hiccup, the better economic outlook will continue to benefit credit ratings across the region, with most countries in the periphery likely to retain a stable or positive outlook.

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Inflation, remember that?

Both German and Spanish CPI was released today for August. They can be added to the expanding list of countries in the European area where inflation is coming in higher than expected. Germany reported 1.8% year-on-year, with Spain at 2.0%.

To put these figures into context:

  • The average inflation in Germany over the last 5 years was 1.2%, and 0.6% in Spain.
  • The average inflation in Germany since the euro was formed was 1.5%, and 2.2% in Spain.
  • The average inflation in Germany since Bloomberg records began (in 1997) was 1.4%, and 2.2% in Spain.
  • The inflation rate in Germany when the ECB started quantitative easing (QE) was 0.2%, and -0.8% in Spain.
  • The inflation rate in Germany when the ECB expanded QE (in June 2016 post the Brexit vote) was 0.1%, and -0.9% in Spain.
  • The inflation rate in Germany when the ECB announced the extension but reduced amount of QE (the first taper) was 0.5%, and 0.0% in Spain.

France and Italy release their figures tomorrow, so it will be prudent to keep an eye out for that. With regard to inflation, these countries remain the laggards with France at 0.8% year-on-year and Italy at 1.2%. After the figures today, I would expect these to come out higher than forecast – with the obvious implications for ECB policy.

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Greece-ing the wheels of recovery

Greece returned to the international bond markets last week with its first issuance since 2014, which at the time was its only issuance since the European Sovereign Crisis when the vast bulk of its debt was ‘restructured’. This return to the market is another small step in the long road back to financial health. Around half of the issuance was bought in exchange for existing debt but some new investors subscribed to the deal, some at least likely to be from outside Greece.

In a small way this should help the Greek banking system by injecting funds from outside Greece into the country, and allowing the amount borrowed under the Emergency Liquidity Assistance (ELA) programme to continue to reduce – something that is probably necessary before the 2015 capital controls are removed. Since 2015, many changes have occurred in Greece and it may surprise some that the outlook is looking much more favourable. Economic growth has turned positive, helped by firm Eurozone economic performance. Unemployment levels, although very high, have been falling since 2014. The fiscal position also looks better, with Greece recording a primary surplus in 2016.

The outstanding level of total government debt is still enormously high and is almost universally agreed as being unstainable in the long term. That said, in view of these more recent positive developments, Greece has been upgraded by rating agencies Standard & Poor’s and Moody’s over the last 12 months. Still rated at a worrisome B- at best, but at least going in the right direction. For this reason Greece offered a credit premium of near 5% over German debt in its recent issuance. This compares with the 1.3% spread that Portugal offers, the next ‘worst’ of the major countries that are active in the debt markets.

The credit trends are not isolated in Greece. Two of the other former ‘PIIGS’ countries, Ireland and Spain, have also seen upgrades in their credit ratings in recent years, and while Portugal’s rating has remained stable, Fitch has upgraded its outlook to Positive. Only Italy has seen a downgrade recently – but even there the outlook looks, for the short term, reasonably sanguine. The revival in economic growth and the long-awaited action regarding the banking system should mean stability for the foreseeable future. The good news can continue.

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Seasonal Pair Trade: Sell Belgian, Buy Swiss (Chocolates)

We have a lovely custom here in the Kames office of buying chocolates for the team after we return from our holidays. Occasionally one of the healthier team members veers into the natural sugar space, but in general the tried-and-tested combination of cocoa and sugar goes down the best. Summer is a good time for treats, many from far-flung parts of the world, but Europe remains our collective clear favourite.

Europe was an uncertain place last summer. The UK had just voted to leave the European Union and the whole of the region suffered a jolt of confidence as an uncertain future beckoned. A year later, the EU has recovered from the shock, weathered the subsequent political storms and the economy is growing stronger quarter by quarter, whilst the UK languishes.

Since the election of French president Emmanuel Macron, business and economic confidence has strengthened across the EU and is now beginning to be reflected in the ‘hard ‘data. This morning, first estimates of GDP growth in the second quarter for 2017 were released for France, Spain, Austria and Sweden, all higher than expected. The French economy grew at 0.5%, the Spanish 0.9%, the Austrian also 0.9% and the Swedish a punchy 1.7%. Their annual growth rates are 1.8%, 3.1%, 2.2% and 4.0% respectively. This augurs well for releases from other countries for the same period and the Eurozone as a whole may have grown close to 2.2% over the last 12 months. By contrast the UK’s growth rate was 0.3% in the second quarter and 1.7% over the last year.

This renewed confidence is being felt across the whole of the continent – even Greece has recorded an increase in GDP in the first quarter of this year. Unemployment across the region is falling while bank lending is growing moderately. The difficulties of the past five years are receding. This is being reflected in the strength of the euro, not only against the pound (some may find their holidays a touch pricier this year) but also against the US dollar and latterly the Swiss franc. The Swiss franc has been widely used as a safe-haven currency over recent years, used to gain European exposure while avoiding the euro. The currency has appreciated substantially over recent years to much protest from the Swiss. This week the President of the Swiss National Bank, Thomas Jordan, reiterated that in their view the currency was overvalued and that they would do all they can to weaken the currency by keeping monetary policy accommodative and by intervening if necessary.

We fully expect the European economic renaissance to continue, and if it does we may all be swapping our post-holiday Belgian bonds, as well as chocolates, for Swiss ones in the months to come.

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UK election positives

It is early days yet but it looks like Theresa May is going to be returned as prime minister as the Conservatives form a government with support from the Democratic Unionist Party (DUP). On first glance it seems a bit of a mess but taking a closer look at the results there are some positives.

Firstly, the share of the vote taken by the mainstream parties has risen as a proportion of the vote. Or putting it another way, the share of the vote taken by the extremes has fallen. The country as a whole has moved towards the middle. In England, from Right to Left, in Scotland from independence (as supported by the SNP) towards unionist, and in some places, from Anti-EU (Tory) to EU (Liberal Democrats).
What does this mean for policy? Perhaps the same – moving towards the centre, compromising on the issues that the UK faces, which could be a positive outcome.

So for example, the probability of a second independence referendum in Scotland has been reduced.  Many SNP seats were lost on this issue. Scotland is not usually prone to voting Conservative but in this election they represented the strongest voice against Independence.

Negotiations with the EU will have to be less extreme, particularly as the DUP does not want a ‘hard border’ with the Republic of Ireland. You could make the argument that a cross-party team could be appointed to lead negotiations in the national interest, but maybe that is too farfetched. However, with the decline of UKIP, it doesn’t seem likely that the current position can move any further anti-EU.

With regard to tax and fiscal policy, we can probably expect some movement towards the left, i.e. higher taxes and higher public expenditure; the Conservatives lost badly on this issue to Labour. We can probably expect the pledges regarding minimum wages being fulfilled and some of the cuts that were floated (e.g. school lunches) being abandoned.

What does this mean for UK fixed income? Probably very little, with easier fiscal policy being outweighed by reduced extremist political risk. And sterling? It could be positive depending on the Brexit negotiating stance. Monetary policy is likely to stay stable thus supporting fixed income, sterling has depreciated a lot versus both euro and US dollar over the last year, so this political event – as messy as it is – in my view is unlikely to push sterling to new lows.

Politics getting in the way – again

One of the biggest surprises so far this year has been the strength in the Italian economy. In Q1 2017 Italy posted a 0.4% increase in real GDP, the strongest quarter since the European Sovereign Crisis. Meanwhile composite PMIs are reaching new highs, unemployment is finally falling (now 11.6% down from a peak of 12.6% in 2014) and inflation has picked up to 1.5% from around 0% where it has been for over two years.

True, total government debt to GDP is still high at 132.6%. For this ratio to fall, nominal growth must exceed the budget deficit (2.4% of GDP) and there is a small and rising chance that this can be achieved in 2017.

However, politics as always is getting in the way; political developments is certainly the key negative from the rating agencies’ standpoint right now. The failure to reform the senate last year was a step back in the reform process and the current electoral law reform is progressing slowly.

For Italian government bonds this means volatility over the next few months. The latest day an Autumn election can be called is 3 September, for a 22 October vote. And the precondition is the electoral law being passed in July. Irrespective of when the vote takes place, I think it is extremely unlikely that leaving the EU/Euro as a popular policy would get off the ground (around 67% are in favour of using the euro, 15% are opposed and the rest don’t know) but this won’t stop markets being concerned about it.

Where this differs from our experience in France earlier this year is that the current spread on Italian government bonds (over bunds) is already pricing in some political risk. The Italy/Bund spread is currently 200bps, having been as low as 100bps last year. Our view currently would be to buy on further weakness rather than chase the market. We expect there to be some good opportunities to make money through this election period, keeping in mind the potential for volatility.

UK election; early thoughts

It seems a done deal that the Conservative Party will win the 2017 General Election and will increase its majority in the House of Commons. The Conservatives are around 17 points ahead in the opinion polls and the Labour Party’s election campaign to date can best be described as unfortunate. Senior party members appearing to have little knowledge of basic arithmetic and the leakage of the manifesto before the official launch haven’t helped.

The gilt market and sterling are heading into this political event with a reasonable sense of calm; unusual in the context of the last three years of potentially destabilising political events, starting back with the Scottish Referendum in 2014. The expectation appears to be that an increased majority in the House of Commons gives Theresa May the negotiating power to negotiate a ‘better’ Brexit. Many have interpreted this as ‘softer’ i.e. closer to the EEA (European Economic Area) or EFTA (European Free Trade Area)-type arrangements, rather than the imposition of hard borders and resorting to WTO rules regarding trade. This has led to sterling strength against the euro and the US dollar in recent weeks.

Unfortunately it is not clear what her Brexit negotiating stance is yet. On closer inspection of the opinion polls, we see that it is the UKIP support that has collapsed and switched to the Conservative Party. The Conservative manifesto has not been published (or leaked) yet so we are still to see if the currency and bond markets have made the right assessment of a ‘better’ Brexit. What we do know is that Theresa May is firmly rejecting the idea of Free Movement of Workers, with her commitment to reduce immigration to less than 100,000 per annum. This concept is completely at odds with the pillars of free trade in the EU, EEA and EFTA.

Sterling has appreciated over 2% on a trade-weighted basis over the year to date. Gilt yields have fallen from 1.5% at the 10-year maturity to closer to 1.0% as concern over imported inflation abates.   It seems to me that although the outcome of the election is of little dispute, the outlook for Brexit and the UK remains uncertain, and the risks rise again on 8 June.

Will there be a rate increase in the Eurozone?

On Tuesday this week the European Central Bank released their quarterly Bank Lending Survey for the Eurozone. This is a comprehensive document available in the ECB’s website that covers the lending behavior of 140 banks across the Eurozone. Click here to view.  The headline message is clear: both credit supply and credit demand are improving. This augurs well for a continuation of the often under-reported recent robust economic performance of the Eurozone, with many commentators preferring to speculate about political change instead.

Another feature that also stands out is that the banking sector as a whole detests the policy of negative deposit rates.  85% of banks surveyed reported in the first quarter that it was having a negative effect on net interest income.   This is nothing new as each survey since the negative deposit rate was introduced has provoked a similar reaction.   From the ECB’s view, volumes of lending are up as a result of the policy and lending rates are down, so a successful policy to some extent nevertheless.  This somewhat controversial policy is benefiting those in the economy that want to borrow money whilst causing a headache for the banking sector.

As the European economy recovers, speculation is now turning to the idea that the ECB is going to start to remove some of the emergency policies that were put in place last year. So what will they do first, raise the deposit rate or stop quantitative easing?  Raising the deposit rate will benefit the banks by elevating net interest margins and it may also have the effect of increasing short term interest costs within the economy.  Stopping QE first may have the effect of increasing long dated bond yields and increasing long term borrowing costs, maintaining banking sector dissatisfaction.

The debate is on!  The ECB meets today to talk about monetary policy.  At this meeting there is not expected to be any change, but the Eurozone bond market participants will be listening keenly in the post meeting press conference to see if they can detect a bias to one or other policy.  Yield curve and cross Eurozone market opportunities, and also credit sector opportunities will present themselves if a bias is signaled.