Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.
Logo of Bond Vigilantes
Tuesday 19 March 2024

Against the backdrop of stubbornly high – albeit receding – European inflation, the ECB’s Governing Council decided yesterday to raise its policy rates by yet another 25 basis points. This marks the tenth consecutive hike and lifts the ECB’s deposit rate, which had been at -0.5% only in mid-2022, to a whopping 4%. The burning question on many investors’ minds is, of course, was this the final hike of the cycle?

Source: Bloomberg (15 September 2023)


The answer is most likely yes. Admittedly, ECB President Lagarde carefully avoided any definitive statement. Otherwise, she would have needlessly given up optionality. But the passage, “key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target” in the official press release is probably as explicit as it gets in the world of intricate central bank speak. Unless European inflation stages an unexpected resurgence, the ECB has reached its terminal rate. That’s how bond markets interpreted the ECB’s decision, which was widely regarded as a “dovish hike”, sending bond yields lower across the board.

Source: Bloomberg (15 September 2023)


There are two good reasons for the ECB to take the foot off the gas. Firstly, it is estimated that it can take up to 18 months before the economic impact of interest rate decisions is actually felt. With European core inflation beginning to ease off, it might be prudent for the ECB to pause and observe the effects of its ten consecutive rate hikes unfolding over the coming months. Secondly, the macroeconomic outlook is getting noticeably bleaker. The ECB acknowledged that tightening financial conditions have dampened domestic demand in Europe. In combination with the weakening international trade environment, this has prompted the ECB staff to lower their economic growth projections significantly. Going forward, the euro area economy is expected to grow anaemically by 0.7% in 2023, 1.0% in 2024 and 1.5% in 2025. There is only a fine line between fragile growth and a “hard landing”, of course, a scenario which the ECB would like to avoid. Holding fire on rates for now might be the best course of action as delivering further hikes could push (parts of) the euro area into a recession.

If it’s really going to be all quiet on the rates front, what’s next for the ECB? I’d expect the focus to shift towards the asset purchase programmes. While I wouldn’t necessarily assume that actively selling bond holdings Bank-of-England-style will be seriously considered in Frankfurt, questions around reinvestments will continue to bubble up. As a reminder, the size of the ECB’s asset purchase programme (APP) portfolio is shrinking as, from July 2023 onward, the Eurosystem no longer reinvests the principal payments from maturing securities. This does not apply to the pandemic emergency purchase programme (PEPP), though. The ECB intends to carry out reinvestments of principal payments within the c. €1.7 trillion PEPP bond portfolio at least until the end of 2024.

Being asked about PEPP reinvestments at the ECB press conference yesterday, President Lagarde was quick to dismiss any speculations about a potential change of tack. And, from her point of view, a certain reluctance of scrapping reinvestments, which would shrink the PEPP’s size and importance, is understandable. Unlike the APP, which imposes strict capital key-based rules on how to allocate bond purchases across the euro area, the PEPP offers the ECB much higher degrees of freedom. Created against the backdrop of mounting pressures for the European periphery at the height of the Covid-19 pandemic, PEPP investments can, for example, be disproportionally directed towards peripheral bond issuers. If push comes to shove, the PEPP offers the ECB, in theory, enough flexibility and firepower to prevent the spread between peripheral and core European bonds from diverging beyond reason. In this sense, the ECB understands the PEPP as a spread management tool. It’s hard to let go of such a powerful instrument and see it slowly fade away by a discontinuation of reinvestments.

That being said, I still think the PEPP’s days are ultimately numbered. The dark days of the “pandemic emergency” – the clue is in the name – are long behind us. Carrying on with PEPP reinvestments feels like an anachronism. And it contradicts the ECB’s pivot away from an ultra-loose to a much tighter monetary policy stance in light of euro area inflation numbers running well above target, thus creating potential credibility issues. I, for one, would be surprised if PEPP reinvestments would really take place until the end of 2024.

Summary: After 16 – yes, sixteen! – years, Chancellor Merkel’s term in office is eventually drawing to a close. Market participants seem to be paying surprisingly little attention to the upcoming federal elections taking place in Europe’s biggest economy in less than two weeks though. This could however backfire as, judging by the latest opinion polls, a change in German politics is looming ahead. 

The days of the famous – or infamous, depending on who you ask – “Schwarze Null” (black zero, Germany’s commitment to balance its budget) might be numbered, just like those of Angela Merkel’s chancellorship. If Olaf Scholz, the Social Democratic Party’s candidate for Chancellor of Germany and current front-runner in opinion polls, replaces Angela Merkel after the elections, this would have a meaningful impact on Germany’s fiscal policy stance. The election manifesto of the Social Democrats leaves little doubt that Scholz’s party considers fiscal austerity entirely the wrong approach in the post-Covid environment. But would a Scholz government immediately end Germany’s love affair with austerity and bring the country’s public debt level of around 70% closer to the Euro area average of nearly 100%?

Source: M&G, Eurostat.  *19 countries (from 2015).
 

Well, not so fast. The German constitution imposes strict rules in this regard, limiting annual federal net new debt issuance to a measly 0.35% of GDP. And a Scholz government wouldn’t have the necessary two-thirds majority in both chambers of parliament to get rid of the so-called “Schuldenbremse” (debt brake) altogether. But the German constitution leaves a bit of wiggle room to get around the 0.35% limit in the event of natural disasters or other extraordinary emergency situations. And I think it is fair to say that, within the German constitutional framework, the Social Democrats may try to exhaust all possibilities to raise debt levels to fund public spending. Bond investors should thus brace themselves for heightened levels of German government bond issuance, which may put upward pressure on Bund yields.

After softening Germany’s stance on domestic fiscal discipline, a Scholz government would likely be rather lenient towards public finances elsewhere in Europe too. We should also expect further steps towards European fiscal integration. The election manifesto of the Social Democrats downright swoons over the EU Recovery Fund, praising it as a seminal milestone towards European solidarity. Hence, a Scholz government would likely be very supportive of any future pan-European projects combining joint debt raising with public investments tilted towards structurally weak areas. This could give a further boost to peripheral European risk assets, such as Italian and Spanish government bonds.

Source: M&G, Bloomberg (9 September 2021).
 

It should be noted, however, that at current yield levels – at the 10-year point, Italian and Spanish government bonds are trading only 105 bps and 65 bps, respectively, wider than German Bunds – a large portion of the compression trade has already played out. Advances in European fiscal integration under a Scholz government might cause some further tightening but a complete disappearance of peripheral risk premiums, last seen before the Global Financial Crisis, is a highly unlikely scenario.

Another aspect that becomes abundantly clear in the election manifesto of the Social Democrats is the party’s strong commitment to sustainability goals, and climate neutrality in particular. In fact, the word “Klima” (climate) is mentioned a whopping 67 times in the text or, on average, once a page! Large-scale public investment programmes targeted at green infrastructure and technological innovation are likely to be launched in order to help promote the socio-ecological transformation of the German economy, especially if the Social Democrats form a coalition government involving the Green Party. Undoubtedly, such a profound government-backed push towards sustainability would produce winners and losers within corporate Germany. It is our job as active investors to assess which companies would be well-positioned to thrive in this rapidly shifting environment and which would struggle or might even be put out of business entirely.

German politics in general might lack the thrill and glamour present in other European countries. Under Angela Merkel, things have been steady as she goes for a very long time. But investors ignore the upcoming elections at their peril as material changes in fiscal policy, European integration and sustainable industry transformation may well be right around the corner. 

The inclusion of the Bulgarian lev and the Croatian kuna in the Exchange Rate Mechanism II (ERM II), which was announced last Friday, marks a crucial step for both countries to becoming the 20th and 21st members of the euro area. Bulgaria and Croatia won’t imminently join the currency union, though. As stipulated in the Maastricht Treaty, prospective members are expected first to demonstrate at least two years of exchange rate stability—in particular no devaluation of their currencies against the euro—in the ERM II. Further convergence criteria have to be met with regards to inflation, long-term interest rates and sustainability of public finances.

Undoubtedly, a membership in the euro area would have profound consequences for Bulgaria and Croatia. But, conversely, there would also be implications for the currency union as a whole when expanding into the Balkans. I survey three of them below.

(1) Rising economic disparity

First of all, economic disparity within the euro area would rise significantly. Using 2019 Eurostat data, Croatia and especially Bulgaria have substantially lower GDP per capita numbers than any of the 19 eurozone members. The GDP per capita of Latvia—currently the worst performing euro area country by this measure—is still nearly twice as high as Bulgaria’s figure. Moreover, Bulgaria’s GDP per capita is only around one quarter of the euro area average and less than 10% of Luxembourg’s number. That’s a substantial discrepancy. In comparison, GDP per capita differences among the 50 U.S. states are much more benign. The figures of Massachusetts at top of the list and Mississippi at the bottom are only off by a factor of two.

Rising disparity would by no means be limited to GDP per capita. Also with regards to annual net earnings, disposable income, labour cost levels, etc., the lower bound of the euro area range would be shifted downwards when including Bulgaria. It should be noted, however, that there are other key economic parameters, such as unemployment rate or GDP growth, in which Bulgaria and Croatia have performed better than the eurozone average. Still, I think it is fair to say that the expansion into the Balkans would be accompanied by growing heterogeneity and inequality within the eurozone, which begs the question of what this may mean for cohesion and stability of the currency union.

(2) Lower average government indebtedness

Second, average government indebtedness in the euro area would decline, if only marginally. Based on Q4 2019 Eurostat data, the government debt-to-GDP ratios of both Croatia (73.2%) and, even more so, Bulgaria (20.4%) are below the euro area average. In fact, Estonia (8.4%) is the only eurozone member with an even lower ratio than Bulgaria.

And, at least before the COVID-19 crisis struck, there was little reason to assume that government indebtedness was on the rise in Bulgaria and Croatia. In 2019, both countries had a budget surplus—+2.1% for Bulgaria and +0.4% for Croatia—whereas the euro area as a whole featured a budget deficit of -0.6%.

It should be noted that Croatia’s debt-to-GDP ratio exceeds the 60% maximum level, enshrined in the Maastricht Treaty, by more than 10 percentage points. But the rule hasn’t been enforced zealously in the past, to say the least, as both Italy and Greece joined the euro area with government debt-to-GDP ratios beyond 100%. Moreover, it is anybody’s guess whether or not the 60% limit will carry significance at all in a post-COVID-19 world in which public debt levels will have risen drastically across the board.

(3) Dilution of voting power of smaller economies in the Governing Council

Third, the expansion of the euro area into the Balkans would shift the power balance in the Governing Council of the European Central Bank (ECB) more towards the larger economies. The Governing Council is the ECB’s main decision-making body and is responsible for setting the monetary policy in the euro area. It comprises six Executive Board members and the governors of the national central banks (NCBs) of the eurozone’s member countries.

Up until 2014, all council members had both a voice and a vote at every Governing Council meeting. However, over the years the number of eurozone countries, and thus Governing Council members, grew, making consensus-building and decision-making increasingly challenging. Therefore, when Lithuania joined the euro area on 1st January 2015, a rotation system, not dissimilar to the one used by the Federal Open Market Committee of the Federal Reserve, was introduced.

In the new system, the total number of voting members in every Governing Council meeting is set at 21. The six Executive Board members have a permanent voting right at every meeting. The remaining 15 votes are allocated between the 19 NCB governors, who are split into two groups. The NCB governors of the five largest eurozone economies—Germany, France, Italy, Spain and the Netherlands—form the first group and share four votes. Voting rights rotate monthly, which means that every month one of these NCB governors will not be eligible to vote. The second group comprises the NCB governors of the 14 smaller eurozone economies, who share the remaining 11 votes. Hence, on a rotating basis, three of these NCB governors have to forgo voting at each Governing Council meeting. It should be highlighted, however, that Governing Council members without a current voting right are still allowed to attend meetings, present their arguments, participate in the discussions, and thus influence the decisions of the voting Governing Council members.

As it stands, the current voting system—21 votes in total, with tiering of NCB governors into two groups—will persist as and when Bulgaria and Croatia join the euro area. As both countries would be classified as smaller eurozone economies, the 11 votes reserved for this group of NCB governors would then have to spilt by 16, and five of these NCB governors wouldn’t be able to vote. The voting power of smaller economies in the Governing Council of the ECB would thus be diluted and the balance of power would shift more towards the larger economies.

Wowsers, the U.S. labour market never ceases to amaze bond investors. After the cataclysmic April U.S. employment report—nonfarm payrolls (NFP) had dropped by 20.7 million and the unemployment rate had shot up to 14.7%—there was broad agreement amongst market observers that May would prove to be another challenging month. In a Bloomberg survey of 78 economists, the most bullish forecast was a NFP decline of 800,000. The median NFP projection indicated a loss of 7.5 million jobs, while the unemployment rate was predicted to approach Great Depression levels of around 20%.

But—surprise, surprise—the unemployment rate actually fell to 13.3% as the U.S. labour market added a record 2.5 million jobs in May. This means that the median NFP survey forecast was off by a whopping 10 million, a truly spectacular miscalculation. How could this happen? How could so many esteemed economists fail to predict the resurgence of the U.S. job market? Pundits were quick to point to misleading jobless claims data and an underappreciation of the effects of the U.S. government’s relief measures. But I think the real issue is more fundamental. The COVID-19 induced economic downturn is in many ways uncharted territory. The unprecedented nature of the crisis calls into question the applicability of standard economic models.

As bond investors we therefore have to come to terms with elevated levels of uncertainty. Friday’s U.S. employment report wasn’t the first macroeconomic surprise of late—albeit the most remarkable one—and in all likelihood it won’t be the last. Needless to say, unexpected economic data points do move markets. On Friday, driven by U.S. job data, the 10-year U.S. Treasury yield jumped up by nearly 10 basis points (bps) while the spread level of CDX HY, a bellwether of U.S. high yield credit risk, collapsed by nearly 50 bps. This increases the risk of investors being caught on the wrong foot. Considering the ultra-low levels of core government bond yields and the strong recovery in credit markets over the past two months, the margin of safety isn’t particularly generous. Hence, in my view, it is prudent to avoid an overly directional portfolio positioning and balance risk exposures instead.

Furthermore, while Friday’s employment report was certainly a highly encouraging testament to the resilience of the U.S. labour market, investors should be careful not to give the all-clear prematurely. There are still 21 million unemployed persons in the U.S., plus another 9 million not in the labour force who currently want a job. A further 10.6 million classify themselves as employed part time for economic reasons. It will take time for the U.S. labour market to shake off the devastations of COVID-19. There is a risk that investors get overly optimistic, pricing in a frictionless V-shaped recovery, which could lead to disappointment and adverse market reactions. And while markets are fixated on COVID-19, we shouldn’t forget that it is not the only obstacle to economic growth. Trade tensions between the U.S. and China—the bogeyman of 2018—have been building up in the background. Further escalation might damp the speed of economic recovery.

It’s been a wild ride in May for Italian government bonds, so-called Buoni del Tesoro Poliennali (BTPs). The yield spread of 10-year BTPs over 10yr German Bunds first rose to c. 250 basis points (bps) after the German Constitutional Court had ruled that the ECB’s Public Sector Purchase Programme (PSPP) was partly unconstitutional. Subsequently, the Italian risk premium collapsed to c. 190 bps when the COVID-19 situation started easing and details around the proposed EU recovery fund were unveiled. European bond investors are scratching their heads about the direction of travel for BTPs, going forward. In my view, we have to take into account three key aspect—the Good, the Bad and the Ugly.

The Good: Next Generation EU

Clearly, the European Commission’s plan to launch ‘Next Generation EU’, a €750 billion EU recovery instrument, is excellent news for the European periphery and especially Italy. The proposal combines joint borrowing at the European Commission level with the provision of grants and loans to the regions and countries most affected by COVID-19. The European Commission went above and beyond what many political observers had previously considered possible by clearly prioritising grants over repayable loans. In fact, two thirds of Next Generation EU funds, i.e., €500 billion, would be distributed in the form of grants. Italy alone would receive more than €80 billion in Next Generation EU grants, more than any other country.

Beyond immediate crisis relief, Next Generation EU could have more far-reaching implications. Many a commentator enthusiastically referred to the Merkel-Macron plan for a grant-focused EU rescue fund, on which Next Generation EU is based, Europe’s seminal ‘Hamilton moment’. If this is the case and the EU really moves towards fiscal integration, we should expect yield dispersion in the Euro area to drop sharply. In this scenario, BTPs are very likely to perform particularly well. With the exception of Greek debt, Italian BTPs are currently trading at a higher risk premium over Bunds than any other Euro area government bonds—more than 90 bps wider than Spanish bonds at the 10-year point, for example—thus offering a greater potential for spread compression.

In my view, there is considerable downside risk to the BTP compression trade, though. So far, Next Generation EU is just a proposal, albeit a bold one, which still requires support from EU member states. It is entirely within the realms of possibility that the plan is watered down, delayed or scaled back in the process. In fact, Austria, the Netherlands, Sweden and Denmark—the so-called ‘frugal four’—have already presented a counter-proposal, based on repayable loans rather than grants. Chancellor Merkel, one of the architects of the proposal, is also facing headwinds at home, not least within her own party. One of the key points of criticism is that allowing the European Commission to borrow €750 billion on behalf of the EU to fund Next Generation EU could be construed as European debt mutualisation through the back door.

The Bad: Italy’s economic outlook and debt burden

Even if Next Generation EU is implemented as planned, it could turn out to be merely a one-off measure rather than a Hamiltonian watershed moment ushering in a new era. If in the end European fiscal integration proves elusive, Italy’s Next Generation EU boost might be short-lived and markets are likely to shift their focus rather swiftly back to the country’s fundamentals, which do not give occasion to overwhelming optimism. Even before COVID-19 struck, economic growth in Italy was anaemic. The economy already contracted in the final quarter of 2019 by 0.2%. The latest quarter-on-quarter GDP print (-5.3% in Q1 2020) is concerning and distinctly weaker than for the Euro area as a whole (-3.8%). According to a recent Bloomberg survey amongst 32 economists, the Italian economy is expected to shrink by 10.3% this year.

And while 2020 is going to be a highly challenging year for most economies, what makes the situation particularly precarious for Italy is the country’s high debt burden. According to Eurostat, Italy’s government debt-to-GDP ratio is close to 135%, which is more than 50 percentage points higher than the Euro area average (84.2%). Taking into account the Italian government’s recently announced €55 billion stimulus package, in combination with the shrinking GDP base, the EU Commission expects Italy’s public debt to jump to nearly 160% of GDP this year, a whopping 100 percentage points above the maximum debt level stipulated in the Maastricht Treaty.

So far, the prospect of Italy’s government debt rising to eye-watering levels has not spooked investors. One of the key factors is clearly the ECB’s ultra-accommodative monetary policy stance. The €750 billion Pandemic Emergency Purchase Programme (PEPP) in particular carries weight. Unlike the PSPP, the PEPP gives the ECB a fair amount of flexibility to tilt purchases of public sector securities away from the capital key of the national central banks. When push comes to shove, the ECB could ramp up BTP purchases, thus providing a backstop and calming markets, at least temporarily. Over the long-term, however, I don’t think central bank support alone is going to be a panacea to Italian indebtedness. Unless a credible path towards pan-European fiscal integration emerges, bond markets are likely to call into question the sustainability of Italy’s debt burden at some point.

And the Ugly: Italian politics

One important risk factor around BTPs, which is currently neither debated much nor priced in, is politics. Granted, the situation seems less fragile now than at the beginning of the year, when Eurosceptic opposition party Lega was above 30% in opinion polls. Since then, Lega support has dropped by around 5 percentage points, while Italy’s government coalition has closed ranks and prime minister Conte’s approval ratings have soared.

Growing support for the current leadership in a moment of crisis isn’t unusual, of course. The question is, how long will it last? Chances are that as soon as the nature of the crisis shifts from public health to economic depression, Lega and other opposition parties will gather steam again. Especially in case pan-European crisis responses falls short of expectations, anti-EU political forces would have plenty of verbal ammunition to pull in votes. A number of regional elections, taking place later this year, will be an important litmus test. Investors only have to look back two years in order to remind themselves how sensitive BTP valuations are to political risk in Italy. In May 2018, BTP yields jumped from 1.75% above 3% in a matter of weeks when a coalition government involving Lega took shape and anti-EU rhetoric was dialled up.

Conclusions

Undoubtedly, BTPs have a lot going for them right now. The Next Generation EU proposal has evidently boosted investor confidence in the European periphery. And many market participants expect that the ECB is going to announce later this week an expansion of PEPP purchase volumes by €500 billion, which would be another tailwind for BTP valuations. Hence, it is entirely possible that BTPs spreads continue to compress, at least in the short run. However, medium to long-term I remain very cautious. Without ever deepening pan-European fiscal integration, which may or may not happen, BTPs are very likely to come under considerable pressure again due to Italy’s economic malaise, its towering debt burden and political fragility. In my view, at a spread of c. 190 bps over Bunds investors might not get adequately compensated for the lingering risks.

One of the main topics in the investment grade (IG) corporate bond space over the past weeks has been frantic primary market activity. Every single day, with very few exceptions, there has been a relentless flood of new corporate bond issues. Year-to-date supply has risen to around $970 billion and c. €310 billion in U.S. and European IG primary markets, respectively, thus exceeding by far new issue volumes over the same period in prior years.

From a bond investor’s perspective, roaring primary markets are both a blessing and a curse. On the one hand, as an incentive to buy, issuers offer their new bonds typically at more attractive valuations than their outstanding bonds. This new issue premium (NIP) can be substantial, particularly during times of market distress. Broker research reports have estimated the average NIP in March this year for U.S. and European IG markets at 25-40 basis points, which is a significant concession in the IG space. On the other hand, more attractive valuations in primary markets put considerable upward pressure on credit spreads in the secondary market, which hurts existing corporate bond holders, thus highlighting the double-edged nature of the new issue deluge.

Away from bond valuations, it is genuinely worrying for credit investors that so many companies are currently bingeing on gluttonous amounts of debt. Conventional wisdom has it that a bond issuer, when adding financial leverage through debt-financing, becomes more vulnerable, which in turn increases the riskiness of its debt instruments and puts downward pressure on its credit rating.

The new issue glut is also a profoundly bearish signal. What companies are effectively telling us is that they need to borrow money to boost their liquidity profile to compensate for precipitous revenue declines due to COVID-19. Needless to say, this is not a sustainable business model that can go on forever.

But elevated levels of primary market activity are not all bad news. In fact, I’d argue that the new issue frenzy is again a double-edged sword. Compared to ‘peak panic’ in the first half of March, when primary markets were essentially shut, the situation has undoubtedly improved. A functioning primary market, which is open for business and allows companies to raise capital to fund operating expenses and refinance existing debt, is a necessary condition to overcome the current crisis and the looming global recession. It is encouraging that even companies that are facing severe COVID-19 headwinds can tap into the primary bond markets to meet their current funding needs. Aircraft maker Boeing is the prime example, raising $25bn in the U.S. primary bond market at the end of April.

Ultimately, it all comes down to time horizons in my view. Over the short-term, high new issue volumes are a sign of market resilience. Primary markets are throwing companies a liquidity lifeline, which helps to keep default rates in the IG universe at very low levels and thus prevents a further escalation of the crisis. Over the medium- to long-term, however, many companies will emerge with significantly higher debt burdens. Some will be able to capture the economic post-crisis rebound and reduce leverage swiftly. Others will struggle with debilitating debt levels, though. Interest payments will absorb a fair amount of their future revenues, thus stifling their growth potential.

From a macroeconomic viewpoint, it also brings up the question of how many companies that would have otherwise disappeared given their weak balance sheets and poor productivity will survive based on readily available debt financing, thus circumventing Schumpeter’s famous ‘creative destruction’ principle. Is this a trend that is going to continue? That would mean lower innovative strength and subdued potential growth rates for developed economies going forward, which in turn could lead to difficulties to service debt burdens at some point down the line. It is always our job as active corporate bond fund managers to identify good and bad debtors, winners and losers, but in the post-COVID-19 era, this task seems set to become even more crucial.

It’s been a rough two weeks in bond markets, to say the very least. Risk-off sentiment is reigning supreme. In Europe, looking at my screens this morning, iTraxx Xover—a bellwether of European high yield credit risk—jumped to its widest level since mid-2013, while the yield on 10yr German Bunds dropped to an all-time low below -0.8%.

In previous times of market turmoil, the European Central Bank (ECB) has stepped in to signal more monetary stimulus. In March 2016, after a horrendous couple of months for risk assets, the ECB announced it would ramp up its quantitative easing programme by adding corporate bonds to the shopping list. Even more dramatically, former ECB President Mario Draghi’s famous “whatever it takes” speech in July 2012 is largely recognised as one of the key factors putting an end to the European debt crisis. Considering the recent worsening of the COVID-19 situation and subsequent market reactions, all eyes are now on Christine Lagarde and her comments after the ECB’s Governing Council meeting on Thursday. In my view, essentially three options are available to the ECB this week: business as usual, measured response or big bazooka.

Option #1: Business as usual

In this scenario, the ECB simply acknowledges the heightened risks for the economic outlook and medium-term inflation in the euro area caused by COVID-19, but refrains from altering its monetary policy stance, which is already highly accommodative. The main deposit rate is kept at -0.5% and net purchase volumes under the Asset Purchase Programme (APP) continue to run at a monthly rate of €20 billion. The rationale here would be that monetary policy alone won’t be enough and that the onus is first and foremost on governments and fiscal easing. Rushing into monetary emergency measures prematurely might actually be counter-productive. The ECB switching into full-on alarmist mode could very well spook markets further. Also, considering that the ECB’s deposit rate is already deeply negative, which limits the scope of further rate cuts compared to other central banks, the ECB might conclude that it is sensible at this point to keep as much dry powder as possible to be able to act decisively later, in case the COVID-19 situation continues to worsen.

Although there may be valid reasons supporting a “business as usual” approach, I don’t think it is a likely scenario. First, expectations amongst market participants are high with regards to further monetary stimulus from the ECB. At the time of writing, the implied probability of an interest rate cut on Thursday, using overnight index swaps, is close to 100%. The ECB is under no obligation whatsoever to satisfy market expectations, of course. But avoiding the highly anticipated rate cut might fuel further turbulences in financial markets, something the ECB would rather like to prevent. Second, in a world in which other central banks—e.g. the Fed, the Bank of Australia, the Bank of Canada—have decided to cut rates in response to COVID-19, the ECB could quickly become “the odd one out” by keeping rates steady, which would put further upward pressure on the euro. The currency has already appreciated by around nearly 6% against the US dollar since mid-February. Continued strengthening of the euro would be yet another head-wind for export-driven European companies—and by extension, the eurozone economy as a whole—already suffering from weakening demand and supply chain disruption caused by COVID-19. To be clear, the ECB’s mandate does not involve actively managing the strength of the euro in the FX market. But putting an end to the recent euro rally would at least be a desirable side-effect of a rate cut, albeit not the main reason behind it, and might help in moving European inflation closer to its target through rising import prices.

In an attempt to calm markets, with the additional benefit of dampening the strength of the euro, the ECB is going to take action on Thursday, I believe. If so, the key question is of course how far will the ECB go? This leaves us with options #2 and #3.

Option #2: Measured response

In this scenario, the ECB cuts interest rates by a modest amount, say 10 basis points (bps). This would bring the main deposit rate to a new record low of -0.6%. Simultaneously, monthly net asset purchases are increased to perhaps €60 billion or even €80 billion a month. This would be a tripling or quadrupling in purchase volumes, respectively, from the current level of €20 billion, but it wouldn’t be unchartered territory. The ECB used to run its APP in the past at €60 billion (March 2015 to March 2016 and April to December 2017) and €80 billion a month (April 2016 to March 2017).

I’d say this is perhaps the most likely scenario, but arguably the least desirable one. The danger is that the ECB would get the worst of both worlds. Moderate policy action by the ECB, if not accompanied by substantial fiscal stimulus, is unlikely going to be enough to instil lasting confidence into markets that just shrugged off a 50 bps cut from the Fed. The risk-off sentiment could easily escalate further into a fully-fledged market crisis. Simultaneously, the ECB would have depleted some of its dry powder, thus limiting the scope of any additional emergency policy actions that might be necessary in the future if the adverse economic impact of the COVID-19 outbreak exceeds current projections.

Option #3: Big bazooka

The idea here be to create another “whatever it takes” moment that immediately helps calm down markets and avoid a full-blown panic amongst investors that, if left unchecked, might compromise the stability of the financial system and ultimately threaten the real economy. In this scenario, the ECB acts boldly both in terms of interest rates and asset purchases. Rates are cut by at least 25 bps, which would bring the ECB’s deposit rate to -0.75% and thus in line with the policy rate of the Swiss National Bank. In addition, APP purchase volumes are increased beyond €80 billion a month, perhaps to €100 billion. Importantly, in order to signal to market participants that the ECB still has more firepower to further upscale asset purchases in the future if necessary, certain changes to the APP rules might need to be implemented.

  • Under the rules of Public Sector Purchase Programme (PSPP) within the APP, government bond purchases are guided by the ECB capital key. Due to the combination of Germany’s high capital key weight and relatively low level of indebtedness—Germany ended 2019 with a record budget surplus of €13.5 billion after all—Bunds have become a bottleneck in the programme. In order to create headroom in a meaningful way, the capital key rule could temporarily be suspended, thus allowing the ECB to tilt purchases more heavily towards Italian BTPs, of which there are plenty. Politically this step would be highly controversial, of course. But given that at the moment Italy is more severely impacted by the COVID-19 outbreak than any other European country, the rule change seems at least justifiable. If the ECB ever wants to suspend the capital key, now is the time.
  • The rules of the Corporate Sector Purchase Programme (CSPP) within the APP do not allow for the purchase of bonds issued by banks. Since bank bonds account for around 30%, give or take, of the European investment grade corporate bond universe, their inclusion into the CSPP would help increase capacity considerably. It would also serve another purpose. Banks’ profitability would suffer from the deep rate cut in the bazooka scenario. Generating CSPP demand for bank bonds, thus effectively lowering funding costs, would help soften the blow to the European banking system.

As compelling as it may seem to take out the big bazooka, it is a high-risk strategy. If it works and a veritable crisis—both in markets and within the real economy—can be averted through decisive ECB action early on, Christine Lagarde would reach immediate superstardom amongst central bankers. However, if not flanked by fiscal easing in a concerted fashion, the bazooka approach could also easily backfire. If the measures fall flat, markets continue to tumble and the transmission of monetary stimulus into the real economy fails, there wouldn’t be an awful lot more the ECB could do going forward. And markets would know that the ECB—and other central banks—are at their wits’ end.

In summary, Christine Lagarde is not to be envied this week as the ECB is caught between a rock and a hard place. Inaction or any half-hearted measures might lead to further deterioration in market stability that could soon spiral into a full-blown crisis, affecting both financial markets and the real economy. But going “all in” now in an effort to stimulate the economy and turn around investor sentiment before things escalate any further carries the risk of being left without any room for manoeuvre later. For investors, navigating markets is going to be a tricky exercise. Given that there isn’t any obvious path to take for the ECB—or any other central bank for that matter—it is a risky strategy to bet on any particular monetary policy outcome.

With European media outlets focusing on the coronavirus and storm Ciara this week, only little attention was given to the Irish general election held on Saturday. Undeservedly so, I’d argue, considering that the election results mark a seismic shift in Irish politics. The surge of Sinn Féin, winning 24.5% of the first-preference vote, de facto ended the two-party dominance of Fine Gael (20.9%) and Fianna Fáil (22.2%) — a constant in Irish politics since the country gained independence nearly a hundred years ago.

At first glance, the strong shift of votes towards Sinn Féin, who had positioned themselves as a left-wing anti-establishment party in the runup to the election, seems rather counterintuitive. Judging by most economic metrics, the recovery of Ireland after the European debt crisis has been a truly remarkable success story. For instance, the Irish unemployment rate, which had peaked at around 15% in 2021/12, has fallen by two thirds and is now below 5%. The government debt-to-GDP ratio has roughly halved from its 2013 peak (c. 125%) to currently c. 63%, which is in striking distance to the 60% debt limit specified in the Maastricht Treaty. Consequently, funding conditions have improved dramatically for Ireland. At the height of the debt crisis in 2011, the yield of 10yr Irish government bonds shot up to a whopping 14%, forcing Ireland to accept bailout loans. In contrast, the current Irish 10yr yield is c. -0.1% — pretty much in line with the French 10yr yield — which illustrates how profoundly market perceptions on Ireland have improved in recent years.

But why did Irish voters decide to shake up the political status quo when mainstream politics had helped produce such impressive results? Sinn Féin’s unwavering pursuit of an all-Ireland agenda sets them apart from their more moderate political rivals Fine Gael and Fianna Fáil. An exit poll taken at the Irish election on Saturday suggests that a significant percentage of the electorate (57%) are in support of referendums on Irish unity north and south of the border within the next five years — a key political goal of Sinn Féin.

Although the question of Irish unity may have been a factor for some in the election, there were other factors cited as being more important that unity at play as well. When voters were asked in exit polls on Saturday what was most important to them in deciding how to vote, social issues — namely healthcare and housing — were topping the list. While the Irish economy as a whole has recovered superbly from the grave dislocations caused by the European debt crisis, it seems a significant proportion of the Irish people feel rather left behind. For instance, the Irish residential property price index has risen by c. 85% from its 2013 trough, which is great news for Irish home owners, of course. But, on the flipside, it has become a lot harder for young people and low-income families to get on the proverbial property ladder. Hence, Sinn Féin’s promise to build 100,000 new social and affordable homes, in addition to other left-wing policies, fell on sympathetic ears.

Since social issues seem to have played a crucial role the Irish election, it is worth comparing Ireland to other European countries with regards to key societal metrics. The Gini coefficient, for instance, is a statistical measure of dispersion and is typically applied to quantify the level of income inequality within a population. Lower values indicate lower levels of inequality, and vice versa. Interestingly, Ireland ranks close to the bottom of the Gini range within its European peer group. Sure, the usual suspects (e.g., Norway or the Netherlands) exhibit even lower Gini coefficients. But the level of income inequality in Ireland is significantly below EU average, lower than in Germany, Spain, Italy, Greece or the UK. The picture is slightly less benign for Ireland when it comes to the percentage of people at risk of poverty or social exclusion, another important social indicator. Ireland appears to be a halfway house between core European countries (Germany, France, Belgium, the Netherlands, etc.) with values below 20% and southern periphery countries, such as Spain and Italy, with values beyond 25%. That being said, it’s worth pointing out that Ireland’s poverty risk figure is still below EU average.

So, what lessons can we learn? Frankly, I think it is pretty remarkable that in a country like Ireland, which has been highly successful over many years based on most economic metrics, a left-wing anti-establishment party can swoop up nearly a quarter of votes in a general election. It serves as a stark reminder that even seemingly stable political landscapes can easily erode, when large parts of the population feel that they have been excluded from the spoils of economic growth. Even though Ireland’s Gini coefficient and poverty risk are not flashing red by any stretch of the imagination, social issues, such as housing or healthcare, were very much on people’s minds. These topics are all too familiar in most other European countries and we should thus expect anti-establishment movements challenging the status quo to gain political momentum elsewhere as well. And, just to be clear, within democratic systems these election results are a perfectly legitimate expression of the will of the people.

But there are certain risks attached, of course. When political constellations become more complex, it can become rather difficult to form stable governments. As a reminder, it took Germans half a year to forge a new government after the last federal election. This sluggishness, which affects consensus building and decision-making in fragmented parliament more broadly, can be costly especially when acute crises arise that demand an immediate response. For investors like ourselves, proper assessment of political risk becomes more relevant as election results get less predictable. We shouldn’t be lured into a false sense of security by long-standing political orders but factor in fragility and the expected market volatility that goes along with it.

Lately a growing number of indicators have suggested that the European economy might be out of the woods, heading towards a more robust recovery. For instance, while European inflation remains significantly below the ECB’s inflation target of close to but below 2%, it is worth highlighting that the year-on-year headline rate has in fact doubled from 0.7% in October 2019 to 1.4% in January 2020. Even the manufacturing PMI for the euro area, one of the biggest causes of worry to European investors throughout 2018, seems to have bottomed out in September 2019 and is now back on a mild upward trajectory. Sentiment amongst European investors has also improved considerably. Take, for example, the Sentix economic index for the euro area — a gauge for investor confidence — which has sharply rebounded from its October 2019 low-point, climbing in January 2020 to its highest level since November 2018.

The key question is, of course, whether Europe has genuinely turned the corner or not. I’d argue that it is way too early to give the all-clear signal. First of all, despite the recent green shoots, economic growth in Europe remains anaemic and fragile. In fact, Q4 2019 marks with only 0.1% real GDP growth the weakest quarter in the euro area since Q1 2013. The economies of France (-0.1%) and Italy (-0.3%) outright contracted. In addition, recession risks around Germany have resurfaced with a vengeance. On a year-on-year basis, German industrial production dropped by 6.8% in December 2019, the strongest decline since the global financial crisis. So, things may well get worse before they get better in Europe.

Furthermore, there are several material tail risks lingering in the background that could further darken the outlook for the euro area.

  • Coronavirus: It is of course too early predict the full magnitude of the economic impact of the coronavirus outbreak on China — and, by extension, on global growth dynamics — with any reasonable degree of confidence. If however the situation does take a turn for the worse, European GDP growth would most certainly take a hit. Chinese demand for European product may falter and global supply chains could get disrupted. Apart from the economic drag, any further escalation of the coronavirus situation could also trigger distress in global markets through a retrenchment of risk appetite, as the Federal Reserve Board pointed out in their latest Monetary Policy Report.
  • Trade wars: Although both the US and China struck a more constructive tone — in fact, China announced to halve tariffs on more than 1,700 US products last week — the tail risk of a sudden deterioration or breakdown of talks remains. Even if the US / China trade disputes get conclusively resolved, it is entirely possible that the focus of the Trump administration would swiftly shift to Europe. It is an election year in the US after all and protectionist measures are popular policies amongst a not insignificant part of the electorate.
  • Brexit: After the UK left the European Union on 31st January 2020, the 11-month transition period has begun. The clock is ticking and, if there is no extension, only very little time remains to negotiate a comprehensive trade deal between both parties. The risk for the EU is, of course, that from 1st January 2021 onwards trade with the UK will be conducted on WTO terms, which could disrupt supply chains and dampen economic activity.
  • Italian politics: As we have analysed in a recent blog post, even though Salvini’s Lega was defeated in the Emilia Romagna regional election, the Italian national government remains under pressure due to the rising popularity of Lega on the one side and the decline of support for the 5 Star movement on the other side of the political spectrum. A collapse of the Italian government would send shock waves through European markets and increase political uncertainty that would weigh heavily on the already ailing Italian economy.

In light of these risks — and considering the persistently weak growth data—I find the valuations of European risk assets rather astonishing. At current levels there is hardly any margin for error left. For example, iTraxx EUR 5yr, a bellwether of the European investment grade credit market, is currently trading only at around 44 basis points (bps) and the yield of 10yr Italian government bonds is a measly 130 bps above the 10yr Bund yield. Essentially, there is hardly any margin for error left as we are (almost) back to market levels last seen at the beginning of 2018. And this is what I find surprising, because back then the mood in markets was distinctly more upbeat than today, borderline euphoric. The prevailing narrative was all about global synchronised growth and European recovery. Political risks in Europe were hardly talked about. In short, market participants became complacent.

We all know what happened next in 2018. Trade wars suddenly escalated, anti-establishment parties Lega and 5 Stars chalked up large gains in the Italian election in March 2018 and global economic data took a nosedive. As a result, investor sentiment soured and markets rapidly entered a prolonged risk-off phase causing risk assets across the board to produce deeply negative annual returns. I am not suggesting that history has to repeat itself. But I can’t help feeling that markets have again gotten ahead of themselves and complacency is reigning supreme. Sure, there is ample support from central banks, from the ECB in particular, providing favourable technicals and thus propping up asset prices. But just as a reminder, the ECB was buying assets to the tune of €30 billion a month from January to September 2018 — 50% more than at the moment — and markets still sold off in a meaningful manner. I therefore believe a rather cautious stance towards European risk assets is warranted. Reducing market risk exposure and trading up in credit quality seem prudent measures to me at this point.

All eyes are on central banks these days as major monetary policy decisions have been driving global bond markets. The eagerly awaited September meeting of the Governing Council of the European Central Bank (ECB) has given bond investors much food for thought. In particular, the new round of its asset purchase programme (APP)—announced in true ECB fashion revealing only the bare minimum of details—leaves plenty of room for speculation. So far, we only know that from November onwards net asset purchases are going to resume at a pace of EUR 20 billion per month for as long as deemed necessary to reinforce the accommodative impact of the ECB’s policy rates.

Credit investors like ourselves are naturally very interested in understanding the exact terms of the corporate bond element of the APP, i.e., the corporate sector purchase programme (CSPP). Here we try to provide answers to a few open questions.

How much corporate debt is the ECB going to buy per month?

While the exact percentage of CSPP purchases within the upcoming APP round is unknown at this stage, historic data can help us define a realistic range of potential outcomes. It is important to note that the CSPP share has not been constant over time. Initially, when the ECB was buying EUR 80 billion of assets per month (until March 2017), CSPP purchases accounted on average for around 10% of all APP purchases. However, when overall monthly APP net purchase volumes were lowered first to EUR 60 billion (April to December 2017), then to EUR 30 billion (January to September 2018) and finally to EUR 15 billion (October to December 2018), the average CSPP share successively climbed up to around 18% in the end.

Applying the historic CSPP range of around 10% to 20% of all APP purchases, we can expect net purchases of corporate bonds to be anywhere between EUR 2 billion and EUR 4 billion per month from November onwards. My hunch—and it’s not much more than a hunch, I’m afraid—is that the ECB is going to push CSPP purchases towards the upper end of the range, i.e., between EUR 3 billion and EUR 4 billion per month.

Tilting APP net purchases toward the CSPP would effectively help the ECB buy time. The issue with public sector purchases, as opposed to private sector purchases, is that the capital key requires the ECB to purchase large quantities of German government bonds. Simultaneously, the maximum share of any public sector issuer’s outstanding securities that the ECB is allowed to hold is 33%. So, unless Germany abandons its balanced budget mantra (‘black zero’) and embraces fiscal expansion, thus increasing the Bund supply, the ECB will eventually run out of German government bonds to buy. As rules around the CSPP are less restrictive (capital key does not apply; 70% maximum issue share limit), it would make the ECB’s life a bit easier if a substantial share of net purchases was directed towards the private sector.

Are senior bank bonds going to be added to the ECB’s shopping list this time round?

Highly unlikely, in my view. Although Mario Draghi stayed fairly tight-lipped with regards to the finer details of the new APP round, he briefly noted that the types of APP-eligible assets would remain by and large the same as in the past, thus effectively ruling out the inclusion of bank debt. There had been rumours suggesting that the ECB might add senior bank bonds to the shopping list for the first time in an effort to cushion the blow to European banks’ profitability from further rate cuts. However, the distinctly bank-friendly aspects of the ECB’s most recent stimulus package—more favourable terms on targeted longer-term refinancing operations and the introduction of a two-tier system for reserve remuneration—have taken the wind out of the sails for this line of argument, I reckon.

Which parts of the corporate bond universe are likely to benefit the most?

Again, apart from Mario Draghi’s “expect more of the same” comment, we have very little information to work with. Assuming that the main CSPP eligibility criteria remain in place—euro denominated bonds, issued by non-bank corporations established in the euro area, with a remaining maturity between six months and 31 years and at least one investment grade (IG) credit rating—I would expect single-A rated bonds, French companies and the utilities sector to experience the strongest technical support under the new programme, just like under the old one.

Why did the ECB remove the yield floor for CSPP-eligible corporate bonds?

Interestingly, the ECB has flagged one rule change which is going to affect CSPP purchases. So far, purchases of assets with yields below the deposit facility rate (now -0.5%) were only permissible for public sector debt, but not for private sector debt. This time round, however, the yield floor is going to be abolished across all parts of the APP, including the CSPP. Hence, the ECB could buy corporate bonds yielding less than -0.5% from November onwards.

The actual impact of this rule change, at least in the current market environment, is unlikely to be material, though. In fact, apart from short-dated bonds issued by state-owned Deutsche Bahn, it is pretty hard to find corporate bonds with yields below -0.5%. This could change, of course, in case Bund yields take a leap lower at some point, thus dragging corporate bond yields down with them in the process. In this scenario, the yield on short-dated bonds from other highly rated issuers (such as Sanofi, Novartis or Total) might as well drop below the deposit rate.

In my view, the rule change is mainly of symbolic nature. It is a bullish signal telling credit investors that the ECB would be willing to support the high-quality end of the credit universe regardless of the prevailing yield environment.

Will European IG credit rally like in 2016/17?

No doubt, the fact that the ECB is going to buy once again large quantities of European IG corporate bonds is a material technical tailwind for the asset class, putting downward pressure on credit spreads and volatility alike. That being said, I wouldn’t necessarily expect a repetition of the extraordinarily strong credit bull market of 2016/17 for two reasons.

First, the scope of the new CSPP round is going to be more modest than in the past. Even if the ECB gravitates towards the upper end of its historic asset allocation range and directs a punchy 20% of net purchases towards corporate bonds, the absolute purchase volume of EUR 4 billion per month would still only be around half the amount invested in corporate debt on average each month between June 2016 and March 2017, when the original APP was in full swing.

Second, the entry point with regards to prevailing credit spread levels is less appealing. Before the ECB first announced CSPP in March 2016, investors had been spooked by the potential for a hard landing of the Chinese economy and a dramatic fall in the oil price. Consequently, the ICE BofAML EMU Corporate Excluding Banking Index—a rough proxy for the CSPP-eligible bond universe—was trading at an average asset-swap spread level of around 120 basis points (bps) back then. At this crisis-like level, credit spreads offered a lot of pent-up potential for an aggressive rally. Today, however, the index trades at a spread of only around 80 bps, which limits in my view the scope for further spread compression. I think a fair amount of ECB support is already baked into credit valuations at this point.

Author: Wolfgang Bauer

Get Bond Vigilantes updates straight to your inbox

Sign up to the BV Mailing List