QE is dead! Long live QE!

2019 was going to be all about quantitative tightening, right? Wrong! QE is back on the agenda in a big way, with Christine Lagarde’s forthcoming arrival as new ECB president helping reboot the bond market rally. With input from Crédit Agricole CIB’s financials credit desk, Neil Day explores the opportunities and challenges facing issuers and investors in the post-summer market, where technicals and fundamentals could increasingly clash.

Draghi Lagarde ECB 12 June web

When the eyes of the market were on ECB president Mario Draghi after the 25 July governing council meeting — almost seven years to the day since his “whatever it takes” pledge — one journalist chose not to focus on the rationale for the central bank’s latest decision to hold fire on rate cuts and any other stimulus, but to ask the Italian what he might do when he leaves his current post. Draghi gave nothing away, choosing instead to focus on what might happen to the ECB once he has departed.

“Let me say one thing about my successor,” he said. “I think she’ll be an outstanding president of the ECB. And I’m saying this with the knowledge that comes from having known her for longer than she and I may like to remember.

“And if you think about the way decision-making has been actually done in the IMF, it’s collegial, it uses the vast input of the staff, of economists. It involves discussions with colleagues, with the staff, with the various parts of the IMF. It isn’t much different from what we do at the ECB.”

Since International Monetary Fund managing director Christine Lagarde’s name on 2 July sprung to the fore as the nominated next president of the ECB, speculation has been rife over what this will mean for the central bank’s outlook.

More immediately, the market was just as interested in who had not been nominated.

“The relief is perhaps more about who is not going to be the new president, rather than who will be at the helm,” said Mark Holman, TwentyFour Asset Management CEO. “German Bundesbank chief Jens Weidman was considered to be one of the frontrunners for the post. While Draghi will be remembered for pledging to do ‘whatever it takes’ to preserve the euro, Weidman will be known for trying all he could to prevent some of Draghi’s policies being enacted.

“An ECB under Weidman would have always appeared weaker in times of market distress,” he added “making further attacks on the euro’s viability more likely.”

Largarde’s experience has meanwhile led others to look beyond monetary policy. Didier Saint-Georges, managing director and member of the strategic investment committee at Carmignac, for example, has suggested that “unconventional monetary policy is plainly on its last legs”.

“Consider the eurozone,” he said. “What benefits can we expect to derive from a new bond-buying programme or a cut in key interest rates, given that France is already borrowing at negative rates on maturities up to 10 years and that the yield on Spain’s 10 year bonds is just 0.2%? So even with very high debt loads to contend with, there is growing recognition in Europe and the United States of the need to resort to greater fiscal spending — in coordination with support from central bankers.

“The sense that such political connivance will be unavoidable may help understand — or even justify — the appointment of central bank presidents possessing more of a legal background and demonstrated political savvy than expertise in the technicalities of monetary policy.”

Forced buyers caught up in rally

But in the short term, attention is now focused on what the current president might announce after the next governing council meeting, on 12 September. With interest rates held on 25 July, a cut is now even more widely anticipated after the summer holidays, and expectations of new net purchases under a reactivated asset purchase programme have risen following Draghi’s latest comments.

This has supported the renewed round of tightening in credit markets that occurred on the back of his remarks at Sintra on 18 June, where he said that in the absence of any improvement in economic indicators, “additional stimulus will be required”, with many market participants interpreting this as a signal that bond buying is again on the agenda.

David Riley, chief investment strategist at BlueBay Asset Management, is one investor who believes the rally has legs.

“Credit has posted strong mid to high single-digit total returns in the first half of the year, but this should be viewed in the context of a dismal performance through much of 2018,” he said. “In our view, spreads have room to narrow further and compress, especially for low rated debt that has lagged the broader market rally. Although credit valuations are high by historical standards, valuations are less stretched in a world of structurally lower long-term interest rates.

“In the event of the resumption of ECB bond buying — as we expect — sovereign as well as corporate credit is an unambiguous beneficiary. Despite the rally in sovereign peripheral and corporate credit spreads in June, in our view there is room for further spread compression if and when the ECB announces QE.”

Neel Shah, financial credit desk analyst at Crédit Agricole CIB (pictured), also expects the rally to continue in the short term.

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“Our desk view is for spreads to tighten over the summer period until September,” he said, “and this will be largely driven by the softening tone of the ECB and the announcement of the recommencement of CSPP (corporate securities purchase programme).”

Some investors and analysts nevertheless warn that the more bullish in the market may be getting ahead of themselves. One conservative portfolio manager said that a restart to QE is not yet “a done deal”.

“It will happen if the macro backdrop worsens further,” he added. “But QE is really the last tool the ECB should use and hopefully the last tool it will use.”

However, like others, he has positioned himself long credit, acknowledging that he is something of a forced buyer.

“It’s not a conviction trade,” he said. “It’s pragmatic positioning. I find the valuations to be quite tight and often too tight, but since the beginning of the year people have been talking more and more about some accommodative monetary policy, so I have been buying just like everybody else.

“I added to my portfolio in May because there was a small underperformance of the whole market. And after Sintra I bought a decent amount because, like everybody else, I felt that Mr Draghi was precommitting to something and I didn’t want to fall back behind the market.”

Dynamics support bank capital

Among the sectors to have benefited the most from the rally have been peripheral credits, with the countries’ banks playing their role in this.

“Even previous to the last recent rally we saw after Sintra,” said Shah, “we’d generally seen a compression between peripheral credit and core European credit, driven largely by the sovereign and causing investors to look at credits within Spain and Italy. We’ve seen issuance in Italian paper from seniors to Tier 2s in the last month or so, and we’ve seen issuance in Greek banks, which you wouldn’t have thought at the beginning of this year.

“So there’s definitely a more positive backdrop for issuance for peripheral credit at this moment.”

Investors have meanwhile moved down the capital structure in bank product and extend duration.

“What we’ve seen is a grab for yield and a grab for spread,” said William Rabicano, director, credit trading, at Crédit Agricole CIB (pictured), “with significant outperformance of senior non-preferred and HoldCo paper versus lower beta OpCo, for example. We’ve also started to see clients extend duration, adding much longer dated, 10 year and longer paper as opposed to the tighter five years.

William Rabicano CA-CIB10118

“At the moment it just seems that the compression trade is in full swing, and we fully expect that to continue to be the case, certainly over the short term.”

Subordinated bonds issued by European banks are among the fixed income sectors Carmignac has been favouring, while BlueBay has a core overweight in CoCos in its multi-asset credit (MAC) strategies. Riley at BlueBay said the asset class offers an attractive risk-reward profile, citing US dollar yields ranging from 5% to 7%.

Indeed, Nigel Brady, AT1 trader at Crédit Agricole CIB, said that that the dollar market has been outshining euros.

“You’ve got a lot more money going into that market, notably from US but also Asian retail, and it’s where all the core European issuers are going because dollar funding rates are still lower,” he said. “When rates have backed off a little, demand has tailed off, but when rates are moving lower, there’s plenty of demand — the relative value argument is still there, in terms of the 10 Treasury being at 2% and your average AT1 at around 6%.”

The supply side of the equation is also set to support the AT1 market, according to Brady.

“The other big factor we’ve got coming up in September is redemptions,” said Brady (pictured). “Those due in September have all been prefinanced, so there will be about $5bn-worth of AT1 money to be reinvested when those deals are called. This year we’ve seen that when Santander, for example, was redeemed, a lot of those proceeds were reinvested.

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“There are also some Asian AT1s that were issued in dollars but are now being refinanced in local currency. Since those won’t now be refinanced in the dollar market, either, some of that reinvestment income is going to be feeding through to the market, too.”

A sting in the tail?

Investors’ enthusiasm for financials to some extent depends on whether they view the banking cup as half empty or half full. Riley, for instance, accentuates the positive, noting that while low rates and a flat yield curve are not good for bank profitability and equity, their credit fundamentals remain strong.

However, the conservative portfolio manager takes a dimmer view of the sector.

“The outlook is not that bright,” he said. “For years now cost cuts have permitted banks to stay somewhat on track. The TLTRO may help and should tiering be announced by the ECB, that might mitigate the effects of very low rates. But a big part will depend on investment banking results and I don’t think these will be very good.

“I’m not expecting very bad results, but they will continue to decline, and I think that will prove difficult, first for the equity, but also as a second round effect it might affect their credit.”

S&P Global said that Draghi’s latest monetary policy communication was potentially bad news for European banks in indicating that ultra-low policy rates may be longer lasting than previously assumed.

“As a result, low profitability may become a more persistent structural problem for some European banks,” it said. “Indeed, declining yields on the capital and money markets in anticipation of central bank loosening may be hurting bank earnings already as they eat into interest margins on loans and securities investments over deposits. The possible introduction of reserve remuneration alongside further rate cuts might have some mitigating effect on those banks that hold significant excess liquidity and would suffer more than most from lower rates.

“The prospect of an even more negative interest rate environment contrasts with the gradual normalization of monetary policy we envisaged at the start of the year. We remain mindful of the potential downside risk of these developments for our base case assumptions for European banks’ earnings and business strategies.”

It noted that although European bank creditworthiness is generally well supported by the substantial strengthening in capital, liquidity and funding of the past several years and a degree of economic recovery in the countries that suffered most in the crisis, “banks are businesses — not balance sheets”.

“Management teams will need to start proving to investors that their banks have sustainable business models that are able to adapt to a lower-for-longer interest rate environment,” said S&P.

The discussion surrounding bank credit quality is in some ways a microcosm of a wider debate in the market, namely fundamentals versus technicals, with the ECB still centre stage.

“So far the technicals are stronger,” said the conservative portfolio manager, “but I hope this will become more balanced by fundamentals to prevent the market going too tight because the unwind of all these ECB measures will be a nightmare — we saw that last year.

“I’m very afraid for the whole market.”

Even those taking a less fearful view of the market’s likely development caution that investors could reassess their holdings later this year.

“At some point in Q4 we’ll see investors really looking at whether they are getting sufficiently compensated for credit risk when corporate or financial credits are offering a limited pick-up over sovereign bonds in negative territory,” said Shah at CACIB.

Boris Johnson’s arrival as UK prime minister only three months ahead of the latest Brexit deadline has meanwhile proven a timely reminder of the geopolitical risks that remain, but which have thus far this year been overridden by the market’s one way move.

“Nobody — neither the UK nor Europe — needs the bad effects of Brexit,” said the conservative portfolio manager. “Mr Trump and China, it’s not over yet. And we can’t exclude some eventuality that is not so far priced into the market bringing fundamentals back to the fore.

“I really do hope that the market will realise only trading on technicals — even if it’s totally logical — is very dangerous.”

Main photo: Lagarde and Draghi at an ECB event on 12 June; Credit: ECB/Flickr