Europe on slow crawl upward
Yield curves have been adjusting to investor forecasts on what the European Central Bank (ECB) might do next. Whereas last month there was debate about whether there would be another rate hike in the first half of the year, the consensus is now swinging to the opinion that it will come this month rather than in June. A combination of stronger confidence indices (in particular the German IFO index which rose to a level not seen since 1991) and accelerating money and credit data have convinced investors that the ECB’s hawkish talk will be translated into action sooner rather than later. Yields on 10-year European government bonds have picked up recently.
Interest rates across the globe have been generally on the rise recently, pushed by increasingly optimistic economic growth prospects. The US Federal Reserve raised rates up to 4.75%, and accompanied the action with some hawkish talk which market participants interpreted as a need to raise rate expectations as well. Technical analysis suggests that the US T-bond future, in breaking down through the 110-00 level, is confirming an extension of the bear market perhaps down to an equivalent yield of 5% on the long bond itself. US Treasuries had a first quarter slump of 1.2%. The yield curve inverted once more, this time with overnight rates rising above 10-year Treasury yields.
With so much Cedulas supply in the first quarter of the year, it is hardly surprising that investors have suffered some indigestion and Cedulas spreads have widened. Spanish issuers had always suspected that this might be the case and had organised their pipelines accordingly; quarters two and three should see a significant reduction in supply from this area.
Elsewhere, AHBR, the troubled German mortgage bank, announced that it intended to buy back a maximum of €1.875bn in four of its mortgage Pfandbriefe, reducing each of the four issues to the minimum €1bn Jumbo size, but not taking any issue below the level.
A Swedish issuer looks set to join Europe’s covered bond domain soon. Nordea Hypotek and Stadshypotek have both recently been granted permits by the Sweden’s financial regulator, Finansinspektionen, for the conversion and issuance of covered bonds. It is thought that Nordea will be first off the mark this month.
Investment grade credit
After spreads generally widened in the first quarter, investors are not convinced that now is the time to be raising exposure to credit. With both the ECB and the US Fed suggesting that further rate hikes are on the way, credit spreads still tight by historical standards and event risk in the form of higher M&A activity may yet rise, remaining moderately underweight overall seems to be the consensus view.
Compared to previous credit cycles, this one remains unusual in that credit spreads, both investment grade and high yield, are still lower than when the US tightening cycle was begun almost two years ago. Corporate spreads are not under pressure from the prospect of higher inflation indeed, inflationary expectations remain subdued globally despite the pressure on commodity prices. Second round inflationary effects, via wage inflation are not thought of as a great worry, particularly in Europe given the high unemployment rates compared to those in the US or the UK.
Financials remain the preferred sector and have performed well over the first quarter. Many investors are overweight here, and are offsetting the position with underweight exposure to chemicals, building and basic materials and consumer non- cyclicals.
High yield indices have remained reasonably ‘calm’ as short term interest rates have been risen. Investors now have to worry that the central banks’ actions may prove too much for some of the weaker sectors, such as autos in the US. This is a worry long term as monetary policy on both sides of the Atlantic could hardly be described as hugely restrictive. The counter argument in favour of high yield, and credit in general, points to the strengthening economic conditions, in Europe and Japan.
Interestingly, Moody’s latest default report for February shows that there have been no defaults in the past 12 months. Moody’s are also revising down their forecasts for future global rates. New like this provides investors with a considerable degree of comfort in this asset class as a whole, though individual stocks remain key.
Credit strategists at Dresdner Kleinwort Wasserstein point out that in an environment of M&A on the increase, and rising downgrade activity, historically high yield tends to outperform investment grade. Fallen angels (those corporates whose credit ratings have declined out of the investment grade universe) tend to have widened out, while still in BBB indices, and thus enter the high yield universe at much higher spread levels.
Politics continue to play their part in market sentiment and trading patterns in many emerging markets. The outcome of Israel’s election for example, though a shock for the erstwhile ruling Likud party after their terrible showing, turned out fairly in line with recent poll expectations, so the capital markets remained reasonably calm. More unsettling for the bond market, in fact, was the last CPI figure which at 0.6% month-on-month was twice the market consensus forecast. Israel’s Central Bank duly hiked rates by a quarter at the end of March.
Within emerging Europe, concerns about the situation in Hungary remains acute. Hungary’s twin deficit is huge and worrisome. Elections this month will be very closely watched: the opposition Fidesz party has apparently suggested that if it were to win the election, it would be submitting a new euro convergence programme before the end of June, ie, before the 1 September deadline requested by the European Commission. Some participants have suggested that the Fidesz party views the political pain/ cost of delaying the adoption of the euro as less than that of subjecting people and the economy to rounds of painful spending cuts. Investors, aware that Hungary’s timetable for adoption of the euro was in danger, have already cut back exposure here and may remain on the sidelines until after the election.
The iTraxx indices ‘rolled into their new series on 20 March ’, and the CDX HY index rolled the following week.The ‘roll’ is the name given to the regular updating of the index baskets, and for iTraxx this process is undertaken quarterly. The iTraxx European Crossover basket - that is those entities with ratings of Baa/BBB (and on negative watch by at least one of the agencies) or lower - underwent the most significant changes, with the basket increasing from 40 to 45 names. Although there had been concern that this upheaval might result in some damaging volatility, in the event it happened reasonably smoothly.
Recently, there has been talk of separating out the payment and roll dates in the future, with market participants suggesting that there would be less disruption in the market if these dates were staggered. So far there has been no official comment on this issue.