Eurozone – Battling deflation with a depleted toolkit

Within a slowing global economy that is replete with potential event shocks, the Eurozone stands apart from other major economies in terms of its lack of policy flexibility. Monetary policy has to remain the dominant source of reflation, with the diminishing multiplier effect this entails, while fiscal policy remains overly tight and regulatory policy comprises a notable tightening of monetary conditions. To make matters worse, Germany comprises a “deflation engine” at the heart of the Eurozone. This is an unstable equilibrium with respect to the medium-term durability of the Euro. More immediately a lack of policy flexibility comes at a time when some key inflation measures in Europe are flashing deflation warnings while concerns are building with respect to the banking sector solvency of some Eurozone countries, most notably Italy. The negative interest rate and QE policies of the ECB complicate translating these risks into investment themes given that they seek to suppress credit and risk premium in financial asset. However, the current structural and cyclical forces in Europe reinforce the value in core bond markets despite the ticker-shock of low/ negative yields: Bunds, for instance, should continue to trade more as collateral instruments with an embedded FX option rather than yield products. There is also value emerging in trades that fade the ECB action with respect to select non-core sovereign bond markets, with the proviso that trades need to be structured appropriately: a BTP curve steepener, or short BTPs and long Bunds or USTs in the 10-yr area offer value. Meanwhile, Eurostoxx are expected to persist their marked under-performance of US equities while high yield and financial credit spreads appear increasingly vulnerable, particularly as they lie outside the ambit of ECB QE. Finally, an increasingly structural outflow of capital is expected to establish a medium-term trend of EUR weakness.

EUR 5fwd 5yr inflation swap: warning lights and wailing klaxons regarding the prospect for price stability.

EUR1

Source: Bloomberg

Europe’s challenge to avert deflation

Europe’s depleted reflationary toolkit

Our core view has been that the slow-burning growth crisis of the global economy makes deflation a critical medium-term challenge for policy-makers. Slow growth – particularly with respect to household income – and downside risks to price stability also contain implicit non-linearity risks in economies, financial markets and increasingly the body politic of many countries, as levels of leverage, for instance, become unsustainable at lower levels of nominal activity. (Avoiding the Big Crunch – Policies to prevent a deflationary world.) Regime shifts in policy formation and financial markets are expected to be a feature of the coming years. In many cases, there is reason to hope (however slender) that policy-makers will respond to the economic risks by implementing a policy response that is more appropriately co-ordinated across geographies and reflationary levers. Moreover, there is hope that in an extreme case of a severe economic downturn or the emergence of deflation, many policy-makers would consider “Hail Mary” policy options such as helicopter money. However, the Eurozone stands apart as a region that has the least degree of policy flexibility and hence as potentially one of the most vulnerable regions to an unfolding period of economic weakness. An inability to implement an appropriate policy response runs the risk of a regime shift being seen in terms of the price of credit (increased defaults and debt restructurings) and FX policy (the risk that the Euro does not survive the coming economic downturn).

Chart 1. Eurozone inflation remain worrisome

Source: CEIC

Deflaiton risks are building.

The ECB’s critical challenge, given its mandate, is to address the continued downside risks to inflation. The HICP, at -0.1% Y/Y, remains far below the ECB’s 2% target and the core-HICP is only 0.8% Y/Y. (Chart 1.) Moreover, market expectations of inflation remain un-anchored, with the EUR 5fwd 5yr inflation swap currently measuring a record low of just 1.245%, down from 1.68% at end-2015. (Chart 2.) The ECB keenly watches this measure of market based inflation expectations, and it is flashing a deflationary warning.

Chart 2. Market inflation expectations are flashing warning signs for the ECB

Source: Bloomberg

Draghi’s monetary activism…

At least under the leadership of President Draghi, the ECB cannot be excused of standing idle while deflation risks mounted. Policy rates have been slashed, with the deposit rate currently negative at -40bp. (Chart 3.) The ECB has also tried to maintain loose credit conditions by providing long-term loans to the banking system. It has also initiated a large-scale Asset Purchase Program, which is seeing it purchase EUR80bn a month of government, asset backed, covered bond and investment grade corporate debt securities. The QE program will continue until March 2017 or longer, depending on whether price stability has been achieved. The ECB’s balance sheet currency measures EUR3.1trn (27.7% of GDP), and by next March is expected to top EUR4trn (around 38%). (Chart 4.) The ECB’s Asset Purchase Program is also expected to increase to 15% of GDP by next March compared to 12.7% at present, and is widely expected to have to continue past this point.

Chart 3. ECB has slashed policy rates.

Source: CEIC

…has had a low multiplier effect

While the ECB’s efforts at monetary expansion have been bold, its effectiveness has been muted. This is hardly a surprise since the evidence from across developed economies, is that the multiplier effect of monetary easing is extremely low at a time of persistently insufficient aggregate demand. (The danger of the Fed’s presumed US exceptionalism – real yeilds, illusiry alpha, a declining neutral rate and the need for core recieved positions.) We already noted that inflation remains alarmingly low. Bank credit growth has benefitted from the ECB’s pronounced balance sheet expansion, but remains soft: loans to non-financial corporates rose just 1.2% Y/Y in May. (Chart 5.) Economic growth has experienced a cyclical pick-up – as we discuss below, largely for reasons that lie outside monetary policy – with GDP rising 1.6% Y/Y in Q1 2016, but this has been insufficient to close an output gap that still measures around 2% of GDP. Meanwhile, and as a critical guide to future inflation and economic growth trends, wage growth remains weak, rising by just 1.3% Y/Y at end-2015 and far from the 2+% levels more consistent with the ECB’s 2% inflation mandate. ECB data showed that negotiated wages rose by 1.4% in Q1 2016, the lowest growth since Q4 1991, when the German economy was engulfed by the challenge of reunification. This represents a limited payback for such a pronounced easing of monetary conditions, and motivates Draghi’s frequent call for monetary expansion to be accompnaied by fiscal stimulus.

Chart 4. ECB’s balance sheet has ballooned

Source; CEIC

Oil and Brexit replace a cyclical tail-wind, with a new headwind

As noted earlier, the limited multiplier of monetary easing is even more apparent when one considers that that economic activity in the Eurozone has also recently enjoyed a cyclical pick-up in growth, for reasons that largely lie outside ECB policy. The decline in oil prices, for instance, saw a rise in real disposable incomes in the Eurozone which households used to fund consumption rather than increase their savings. (Real disposable income In the Eurozone improved from –an average of 1.3% in 2013 to -0.2% in 2014 and 0.3% in 2015.) This contributed to the pick-up in GDP growth over the past 12 months. However, this cyclical tail-wind is rapidly ebbing. Real disposable incomes are sliding again (the growth rate peaked in Q3 2015) as oil prices have partly recovered this year. With external demand also weakening, a slowdown in Eurozone economic activity is already starting to unfold. The external shock of Brexit comprises an additional form of head-wind that is likely to weaken consumer and business confidence. (Brexit – “Exit, pursued by a bear” and the need to stay short the GBP and long Gilts”)

Chart 5. The impact on bank lending has been positive but muted.

Source; CEIC

Suppression of credit and risk premia

Of course, the success of the ECB’s monetary easing can be seen less in terms of growth and price stability but more with respect to keeping the Euro intact. By belatedly operating as a true lender of last resort for the Eurozone and undertaking QE, the ECB has suppressed the price of credit and averted a break-up of the Eurozone caused by a fragmentation of sovereign bond markets. This is clearly a non-trivial point of success! Had Draghi not replaced Trichet as ECB President, it is very doubtful whether the Euro would have survived in anything like its current form. However, it is hard to feel confident that Draghi has pushed the Eurozone into a stable, long-term equilibrium as long as growth remains weak and deflationary risks remain prevalent.

 

Europe’s limited reflationary toolkit

The lack of policy flexibility in the Eurozone

It is on this risk that we are worried. The global economy is weak and slowing. Economic and financial market risks are growing. Eurozone growth is set to slow, and inflation indicators are flashing deflation warning signals. Many developed economies face similar challenges, but the Eurozone is notable in terms of its relative lack of policy flexibility.

Interest rate cuts – approaching the political and practical limitations?

The ECB’s move to negative interest rates reflects its zero bound problem. Technically, rates can move far further into negative territory. However, there is growing resistance to further declines into negative territory. In Germany, opposition to negative interest rates – and to ECB’s QE which is driving core bond yields increasingly negative – is growing, as it is considered a tax on prudence, i.e savings. This is exactly what negative interest rates are, as they seek to create an opportunity cost for institutions and individuals saving rather than investing and consuming. But of course German institutions and individuals have the perspective of their own economy, which is a large net saver (8.8% of GDP current account surplus last year), whereas Draghi implements monetary policy at the level of the aggregate Eurozone economy. Nonetheless, while Draghi will rightly continue to resist political pressure from Germany, he himself has admitted that further interest rate cuts will be difficult. The ECB is aware of the risk of interest rate cuts becoming self-defeating if they fall below a central level or are in place for a sufficient period of time, and start to influence economic behaviour in a manner that encourages disintermediation (the storage cost of physical cash, for instance, might become an acceptable alternative to bank deposits) or where household savings rise to offset a perceived long-term lack of return on investments. Admittedly, there is still room for lower interest rates, with many central bank studies focussing on -0.75% rather than -0.4% as the practical lower-threshold for interest rates, implying that the ECB could ease further. A lower depo rate would also increase the number of Bunds the ECB could purchase via QE given it’s need to avoid a capital loss: the ECB cannot buy bonds with yeilds below it’s own depo rate as this would guarantee a loss in a hold to maurity portfolio. However, it’s hard to see policy rates being slashed from current levels in a manner that would notably alter Europe’s growth and inflation outlook. (Avoiding the Big Crunch – Policies to prevent a deflationary world.)

QE – a persistent feature of the European financial landscape.

The bulk of monetary stimulus is therefore likely to have to focus on QE. It is difficult to see QE ending in March 2017 and the persistence of downside risks to price stability means that the Asset Purchase Program is likely to remain a persistent feature of the European investment landscape. The impact of QE on core market yields is becoming increasingly convex as the available float of bonds diminishes. No-where is this more evident that with Bunds. We have often noted that even before QE was initiated, Bunds came to resemble collateral instruments more than yield products, and QE can exacerbate the shortage of these assets. 10yr Bund yields currently yield -18bp, and as QE continues and if we are correct in assuming weaker growth and elevated deflation risks over the coming months, there is the possibility of yields moving down to the -40bp floor (the level of the depo rate) of the ECB’s ability to purchase the instruments via QE without taking a loss. (The importance of Bunds as collateral instruments has meant that shorter maturity bunds have been able to see yields move below this level. Chet 6.) With ECB QE having to be determined by it’s capital key, a growing shortage of Bunds may pressure the ECB into further easing it’s purchase requirements, by extending purchases in the longer-end of the curve, generating a continued rolling flattening.

Chart 6. Bunds have become collateral instruments rather than yield products

Source: Bloomberg

Fiscal activism limited

In many developed economies, we hope (without great expectation at present) for a greater coordination of policy across reflationary levers, with a greater role for activist fiscal policy. However, in the Eurozone this potential remains limited. Austerity is a critical component of the Eurozone’s policy response to the height of the sovereign debt crisis, and a multi-year period of pro-cyclical fiscal consolidation lies ahead. From a Eurozone perspective, Germany needs to inject aggregate demand into the economy by dis-saving, and yet the government has enacted a fiscal policy which exceeds the budget deficit reduction targets laid out in the debt break rules, (Chart 7.). Macro-economic theory has been displaced with a morality play about the need for fiscal austerity to offset years of economic excess, and has laid the foundation for a destructive period of pro-cyclical policy tightening that has actually increased the underlying economic risks in the Eurozone and which Eurozone QE is disguising. The most dramatic example of the failure of austerity is Greece. It is little wonder that the country requires a further debt restructuring when one considers that since a peak in 2008, it’s real GDP has fallen 27.4% and nominal GDP has declined 29%. Less dramatically, Italy was only able to achieve GDP growth of 1.1% (Q4 2015) during the recently cyclical pick-up in Eurozone growth, and real GDP is only at the levels seen in 2000. It is difficult to imagine fiscal policy being a driving force behind Eurozone growth.

Chart 7. Germany rules out notable fiscal expansion

Source: CEIC

 

Regulatory policies are ill-suited to a building Italian banking crisis and a Eurozone NPL problem mirroring Japan’s in the 1990s and 2000

Another area where the Eurozone lacks flexibility is in the area of regulatory and macro-prudential measures. Globally there is little flexibility on this front as MiFID III and Basel III are enacted and comprise a substantial tightening of monetary conditions. However, there remains some room for flexibility in implementation, as was seen in the bank of England’s decision to delay the implementation of the counter-cyclical capital buffer. However, in the case of the Eurozone the weak growth backdrop has fuelled a NPL problem in the banking sector, which is reducing the effectiveness of financial intermediation and thereby restraining economic growth. For many countries in the Eurozone, NPLs are around the level Japan experienced at the peak of its banking crisis in the 2000s. In 2002, Japanese official bank NPLs reached 8.4% of total loans. This compares to current levels of 44.8% in Cypress, 34.7% in Greece, 18% in Italy (5.8% pre-crisis), 14.9% in Ireland, and 12.8% in Portugal. Across the Eurozone, aggregate NPLs measure 12.6% of total loans.

Italy’s “Atlas” can hardly carry the country’s banking system

The greatest concern is the size of Italy’s NPLs given the size of the economy. However, efforts to address this problem are proving hamstrung by Eurozone opposition to any recapitalisation that could be construed as a bail-out to private sector investors. Hence, the EU requires a recapitalisation of the Italian banking sector to effectively wipe-out equity holders and impose sharp losses on holders of sub-ordinated bank debt. This is an outcome that the Italian government finds unnacceptable given the large retail holding of Italian sub-debt (an estimated EUR60bn of these securities are in retail hands) and a concern that the recapitalisation could destabilise sentiment in the banking sector. The outcome is a damaging stasis. As an example of the problem, Italy has established a EUR5bn re-capitalisation fund, funded by Italy’s stronger banks. The size of the fund is small relative to the stock of NPLs (EUR360bn gross and around EUR220-250bn after provisions). Moreover, there is little incentive for an Italian bank to participate in the fund. They cannot sell an NPL to the fund at par as the EU would consider this a subsidy, and even then the EUR5bn fund would be swiftly depleted. It could sell NPLs as a discount, but doing so would crystalise a capital deficit for the bank that sold the loan at the amrket price. The continued stasis with respect to Italian bank solvency increases economic and financial market risks.

The ghost in the machine

At the heart of Europe’s problems remains the economic dominance of Germany and the country’s disinclination to truly embrace Eurozone wide economic policies. The opposition to fiscal Federalism is naturally easily understood. Germany already funds the bulk of Eurozone fiscal bail-out measures, and moving to policies such as bonds being issued at the level of the Eurozone would clearly expose Germany to fiscal losses were the region’s economic growth potential not improved and if economic policy in countries were not implemntated at the supra-sovereign rather than national level. However, if Germany’s economic policies were implemented from the perspective of what was optimal for the Eurzoen as a whole, a very different path would be taken:

  • Domestic absorption. The Eurozone lacks aggregate demand, and Germany is experiencing an aggregate increase in its savings ratio, as reflected in the country’s rising current account surplus. A rising savings rate implies demand being withdrawn from trade partners, which in the current climate of weak growth generates deflationary impulses at the Eurozone level. An optimal policy formation would see Germany implement policies to generate demand and boost growth in the rest of Europe, with fiscal policy rules relaxed to allow for increased public spending which could help increase the multiplier effect of lose monetary conditions. With Germany still maintaining a output gap (albeit small at -0.1% of GDP at end-2016) there may be reason to implement some reflationary policies at a time when economic growth is likely to slow, but this remains unlikely.
  • Germany’s stronger growth means the country faces less deflation risks that the rest fo the Eurozone. The HICP for Germany measured 0.2% Y/Y in June compared to -0.1% for the Eurozone, and the core rate measures 1.1% compared to 0.8% for the Eurozone. However, this still remains some distance from the 2% target level, and that alone should pre-dispose German policy makers to greater reflationary policies. Moreover, were Germany to experience a period of increased inflation the consequences for the rest of the Eurozone economies could be positive, as the country would be sparking inflationary vs. deflationary trends in the region’s.

Chart 8. Rising Target 2 imbalance illustrates the growing imbalances in the Eurozone, and Germany’s role as the region’s deflation engine.

Source: CEIC

Germany is the deflation engine of the Eurozone

However, for reasons cultural and historical (the past experience with hyper-inflation) these arguments have failed to influence German policy considerations and are unlikely to in the future. This leaves Germany as a deflation engine at the heart of the Eurozone. One illustration of the heightened imbalances in the Eurozone is the Target II liquidity data. The flows can roughly be approximated to the balance of payment flows within the Eurozone. In May, Germany’s Target 2 balance showed a surplus of EUR639.2bn, a EUR96bn Y/Y increase. The combined balance for Spain and Italy, by contrast, showed a deficit in EUR565.5bn, which has widened by EUR179.8bn over the past 12 months.

 

ECB credit and risk premia suppression and the market opportunities

The lack of policy flexibility is adding to our concerns about the downside risks to Eurozone markets. The complicating factor, however, is the impact of ECB QE in trying to suppress the price of credit risk and risk premia. This requires a level of precision in terms of initiating trades that can reflect the growing economic risks in the Eurozone, but which are not swamped by the impact of ECB policy.

EUR debt markets

Stay long core bond markets

In a climate of slowing growth, deflation risks and continued ECB QE (and possible further ECB rate cuts), the outlook for core bond yields in Europe is extremely positive – despite the ticker-shock of negative/ low yields for many investors. As we noted above (Chart 6), Bunds 10-yrs and out are likely to increasingly move towards and potentially below the ECB’s depo rate, and similar trends can be expected in other core markets such as France and the Netherlands. Bunds in particular also have the potential benefit of an embedded FX option were we to see a resurgence of existentialist concerns regarding the Euro, since holders of these securities are long redenomination risk from EUR to DEMs.

Credit risk and a tern premium can emerge in non-core curves, despite the ECB

For non-core markets, the problem is more nuanced. Underlying growth, deflation and public sector solvency risks in many non-core countries – particularly Italy – are growing. While this should see a greater credit premium along with an enlarged term premium priced into the respective sovereign debt securities, the ECB’s negative interest rate and QE policies continue to suppress risk premia. Moreover, by negating liquidity risk, the ECB has lowered underlying solvency risks. Of course, the ECB does not provide a permanent suppressant of risk premia. Sizable rises in yields can be seen, as was evident in Portugal earlier this year when yields surged in relation to political risk and the danger that the country might be downgraded by the one remaining rating agency that classifies it investment grade, which could have made the country ineligible for ECB QE. (Between December to February, 5 year PGB yields rose from 0.93% to 2.75% while the 10yr PGB yield rose form 2.26% to 4.10%.) Given the growing medium-term risks in the global and Eurozone economy, there is reason to expect the re-emergence of risk premia in many European sovereign curves, led by Italy where the banking sector is an clear and present risk to growth and financial stability. However, the presence of the ECB means that bearish non-core government bond positions need to be structured appropriately or timed well. For this reason, we favour curve and spread trends as means of expressing bearish views as they offer greater holding power.

“THE BIG ONE” is coming, but not yet

In terms of timing, our view is that while the risks are building, we are not yet at the point of a sustained financial crisis. Brexit, while crisis-inducing in the UK, for broader global markets is expected to have an impact more akin to the December to February slide in risk assets on global markets: short and painful declines, but price declines that can be recovered. The trigger points that we are looking for to spark for a more sustained sell-off in risk markets are a combination of sharp decline in global growth led by a US slowdown, increased credit risk in emerging markets creating liquidity problems (The Saudi Arabian currency peg and the price of convexity.), an FX policy shift in China (China – the non-linear economic and FX implications of the structural slowdown.) and/ or slower growth leading to a tipping point in US and European corporates whereby in the face of diminished margins and rising credit risk, they start to retrench workers and we see an increase in the default cycle (The income-lite recovery trend.).

BTP 2s10s curve steepeners

However, rather than trying to time a move, we favour trades that offer greater holding power. We focus on Italy, where the combination of weak growth, deflation (-0.3% Y/Y in June), high and rising public debt (132.6% at end-2015, up from 115.3% 5 years ago) and a banking sector in urgent need of re-capitalisation make the country increasingly vulnerable. Given the gravitational pull of the front-end of the BTP curve to the ECB’s negative interest rates, the longer-end of the BTP curve is likely to offer the best way to express a view on a rising underlying credit risk premium. One such way is to establish a 2s10s curve steepening trade. The 2yr part of the curve -0.05% is a negative carry long position (thereby increasing the negative carry of a short 10yr BTP trade) but has the potential for capital gains as it rolls towards the ECB depo rate. Front-end (1yr Italian T-bills yield -0.20%.) Moreover, the liquidity support of the ECB should keep the front-end more resilient to a pricing-in of credit risk, in contrast to the height of the crisis in 2011 and 2012 when the curve inverted as a placid ECB failed to avert a looming liquidity crisis in non-core sovereign bond markets. At 126bp, the 2s10s BTP spread is still much tighter than the 204bp seen a year ago. The risk to the trade is of course that a general hunt for yield sees the BTP curve flatten. However, we believe that the growing macro-economic risks, the growing focus on Italy’s banking sector and the growing concern at the Eurozone’s lack of policy options are expected to ensure that the risk premium in the curve increases over the coming months. We see value in scalign into a 2s10s steepener between current levels and 110bp, looking for a return to 180-200bp. In the event if a domestic or external shock, the curve would be expected to steepen sharply. (Chart 9.)

Chart 9. Italian curve should steepen. BTP 2s10s spread

Source: Bloomberg

Bund-BTP spread widener in 10-year sector

Alternatively, a spread trade offers value. Long 10yr Bunds vs short 10yr BTPs is particularly appealing since we expect Bunds to continue to rally over the coming months, and a domestic or external shock – that would weaken BTPs – would add additional support to Bunds. The trade also has a clear implicit embedded FX component since in the event of a Euro break-up, the trades would incur a long-DEM/ DEM bloc vs a short Lira/ rump Euro FX position. The spread is currently 139bp, and even without a domestic or external shock, this has the clear potential to move to 200bp, even if a Bund rally has to drive a 20bp+ of the spread widening. (Chart 10.)

Chart 10. Bund-BTP spread should widen. 10yr Bund-BTP spread

Source: Bloomberg

UST-BTP spread widening in 10-years

An alternative trade we have liked is long 10yr USTs vs. short 10yr BTPs. This trade has an explicit FX component and has less stable correlations that a Bund-BTP trade, but would still have a sizable long convexity component as a trend that pushed BTP yields higher would likely see increased demand for USTs. We have been also strategically bullish on UST and, despite ECB QE and negative rates, expect USTs to increasingly trade at yeilds below BTPs. (Is the US really ready for a rate hike?.) The only current concern is that the pronounced rally in USTs has tightened this spread markedly, and it currently measures -18bp. While this spread could tighten all the way below -100bp, we would favour scaling into the position if we saw a correction that pushed the spread back above 0bp. (Chart 11.)

Chart 11. UST’s to outperform BTPs. 10yr UST BTP spread

Source: Bloomberg

 

Short Eurostoxx

One of the cleanest trades remains to be short/ underweight equities. We continue to see medium-term downside in Eurostoxx, particularly as the Eurozone experiences a continued slowdown over the coming months. Equities are not subject to ECB QE, and so can be more directy sensitive to a likely trend of weakened corporate earnings. (Of course, the portfolio effect of QE pushes liquidity from low yielding government bonds and credit products into equities, but that effect has not been deterministic of the equity market trend since QE was initiated.) There may be reluctance to be short European equities when some sectors – such as banks – have already seen their share-prices pummelled. Moreover, the chronic underperformance of European equities compares to the US (Chart 12) naturally makes investors feel wary of being short European equities. However, the lack of policy flexibility in the Eurozone looks set to generate continued economic and equity market underperformance. In addition, a US-driven economic downturn could see European stocks under-perform those in the US given that the lack of a domestic growth engine could – like 2008-2009 – see countries such as Europe and Japan become higher-beta plays on a US downturn. Finally the current policy framework around re-capitalisation of troubled banking systems leaves selected bank share-prices above zero looking expensive, while even in less troubled banking system, low and falling net inetrest margins, a lack of carry on bond curves, combined with a lack of demand for credit, leaves few sources of immediate growth for the sector at a time when the cost of regulation continues to rise.

Chart 12. Eurozone underperformance of US equities may continue

Source: Bloomberg

 

Credit – High yield and bank credit at risk

Weakening growth and limited policy options are a combination that will increase credit risk and should see credit spreads widen. The complicating factor is that ECB QE now targets investment grade non-financial securities. At a time when net issuance is negligible, the ECB will create a favourable demand-supply imbalance which should support the price of investment grade credit and reduce the sensitivity of these assets to downturn in the business cycle and upturns in credit risk. An expression of a bearish credit view would need to focus on areas of the market which lack such a large and price-insensitive buyer. The iTRAXX main CDS index appears tight at 70bp, but demand-supply dynamics could see the spread tigthen through the 2015 low of 50bp. High yield will likely benefit from liquidity being pushed out of investment grade assets by ECB QE, but there will nonetheless be far less of a “policy subsidy” for the price of these assets. Into periods of heightened credit risk, EUR high yield credit spreads should have an enlarged under-performance to investment grade equivalents compared to past cycles. The sharp,tightening of the iTRAX Crossover spread index to 330bp from 420bp over the past fortnight appears an attractive level to start to establish shorts given that a downturn in the business cycle should help re-stablish the gradual medium-term trend of widening spreads, and provide optionality for a potential sharp increase in credit risk premia. (Chart 13). For similar reasons, we expect senior and sub debt iTRAX indices to experience wider spreads as weakening growth – and a potential further compresison of bank interest rate margins if the ECB lowers rates further and maitains QE – exacerbates banking sector concerns.

Chart 13. ECB QE can help supress credit risk premium in IG, but less so in HY

Source: Bloomberg

The discomfort in being short carry

One key hurdle facing short credit trades is that the current low yielding investment climate makes negative carry positions harder to run, as returns are so hard to come by. Hence, spread trades encompasing long investment grade and short high yield indices may be more appealling. This aversion to negative carry could limit the under-performance of High Yield, although it could also increase the sensitivity of this sector of the market to a turn in the credit cycle given that many wary investors may have been pushed into sub-investment grade spreads by the impact of ECB QE, which renders them potentally ‘weak longs”.

 

The EUR – A growing tide of capital outflows, and – as yet – a relatively muted role as a risk aversion FX play

In terms of the EUR, in recent years this currency pair has shown signs of inheriting the JGB market’s crown as being the “widow-maker” of investment decisions. Weak Eurozone growth, expansive monetary policy and simmering – under-priced – credit risk has at crucuial times failed to generate the widely expected EUR weakness. One factor which supports the EUR is the evolving balance of payments position. Due to insufficient aggregate consumption and investment, the enlarged net savings position in the Eurozone is inflating the current account surplus. This measured 3.1% of GDP in Q1 2016. While this is being recycled by increased capital outflow, the associated increase in foreign asset purchase is leading to a financial account surplus that can turn into a reflux of capital at times of event shock. Into an internal or external event shock, the EUR will be increased biased to initial strength. However, we would not over-state this trend. The strength of potential capital reflux into EUR remains far smaller than is the case in Japan, which has been one of the world’s largest capital exports for decades. While Europe is rapidly accumulating net foreign assets, the total net international investment position in Q4 2015 was a deficit of -4.4% of GDP compared to Japan’s surolus of 67.8%. Short EUR/JPY will remain an appealing “risk-off” trade.

Chart 14. The Eurozone‘s is a rising capital exporter, and the ECB’s compression of risk premia will support overseas outflows.

Source: Bloomberg

EUR/USD biased to parity

On a trend basis, moreover, aside from such risk averse driven short-term spikes in demand for EUR, we expect a medium-term trend of EUR weakness. Even if we do not see a return of concerns of the integrity of the EUR itself, the ECB’s monetary policy is encouraging capital outflows by suppressing domestic yields, risk premia and the price of credit. A steady increase in net purchases of overseas debt and equity securities has inflated the Eurozone’s financial account surpus to 4.8% of GDP. This steady outflow of liquidity combined with an expected increase in growth, deflation and credit concerns in the Eurozone suggests a steady trend of EUR weakness. The greater reliance on monetary policy as a tool of reflation in copmaparrison to the US (potentially at least) also adds to the medium-term downside for EUR/USD. Over the coming 12 months, EUR/USD could move closer to parity.