13 April 2015 Fixed Income in the Euro Zone The quarterly fixed income newsletter of Allianz Global Investors Editorial Don’t fight the ECB FRANCK DIXMIER CIO FIXED INCOME EUROPE Since the European Central Bank (ECB) unveiled Quantitative Easing (QE), negative interest rates have been the world’s fastest-growing asset class. In mid-April, more than 2 trillion euros in government bonds were in negative territory in the euro zone and positive yields on the German curve were not to be found below nine-year maturities. This is a unique situation without precedent in economic and financial history. Navigating in this unknown environment is a challenge and investors’ conventional bearings are blurred: fundamentals have been pushed aside, and Instead, capital flows are, and will continue to be, the real driver of price formation in fixed-income markets in the eurozone. If we take a closer look at the impact of ECB easing, the ECB’s QE amounts to a total of just 11% of euro zone GDP, vs. more than 20% for the Federal Reserve’s recent US QE. However the ECB’s QE will be the equivalent of more than two times net euro zone government bond supply in 2015, vs. one quarter for the Fed’s QE. This serious imbalance between bond supply and demand is a defining feature of the ECBs easing program, and is the main reason for the heavy pricing pressure which we see in Euro Fixed Income markets. While QE is just getting started, it has already had a spectacular impact on euro zone fixedincome markets, with yields falling, yield curves flattening, the euro depreciating and the breakeven inflation point rising. In the short term, this trend is likely to gather strength and squeeze term premiums and risk premiums further… and this is not good news. We are in the process of pre-empting returns outside of any fundamental logic. Through an aggressive and belated QE, the ECB is fuelling a phenomenal bubble of previously unknown proportions in the euro zone interest-rate markets. In this context, the extreme influence of the ECB on prices is leading to more and more questions about QE sustainability being raised. Should the ECB face more and more difficulty to execute its program, it’s very likely that the ECB will introduce more flexibility. The determination of the ECB is intact, and we are not in the camp of those betting for a reorientation or an early termination of QE… don’t fight the ECB! Fixed Income Key macro trends & investment strategy Europe: Quantitative Easing (QE) continues to drive markets Rates for loans to Non Fin Corporation, 1-5 Yrs maturity by country On March 23rd, Mario Draghi announced that, “At this point in time, we see no signs that there will not be enough bonds for us to purchase.” Quantitative easing (QE) continues apace, and the third targeted longerterm refinancing operation (TLTRO) took up a larger than expected 97.8 billion worth of bonds, more than double the market expectations of 40 billion euros for the month. The increased liquidity and expansion of the European Central Bank’s (ECB’s) balance sheet has contributed to a further depreciation of the euro. The monetary transmission function has resumed working in Europe, rates for loans to non-financial corporations are compressing, and loans to non-financial corporations and households are on the rise. (see charts). Coupled with lower oil prices, these elements are anchoring the economic recovery within the Eurozone, with gains being seen in both the manufacturing and service components of the composite purchasers manufacturing index. This should lead to a bounce in Industrial Production going forward. Source: European Central Bank - Data Y/Y growth - March 2015 ECB loans to Non Fin Corporation and Households, annual rates, adj for sales and sec. Source: European Central Bank - Data Y/Y growth - March 2015 EU Big 4 Manufacturing PMI change Core inflation remains stable despite the drop in oil prices, and should economic momentum continue, inflation may see a quicker than anticipated recovery. Europe remains in a position to see continued upside surprises in growth through 2015. We expect rates in the front end to remain at very low levels and EURIBOR rates have the potential to decline even further going forward. Source: European Central Bank - Data Y/Y growth - March 2015 2 Fixed Income Greece: Negotiations remain ongoing Political risk remains in Greece as talks continue between Prime Minister Tsipras and European leaders. The ECB continues to evaluate Greek requests for new emergency liquidity assistance (ELA) on a weekly basis. Regional Elections in the Eurozone: Spain Regional elections in Andalusia provided the Socialist Party, gaining 47 seats, with better than expected results, and the radical left Podemos party with a more moderate gain of 15 seats than had been expected. The Partido Popular party, mired in corruption scandals, lost seats to the new Ciudadanos (“Citizens”) Party, potentially opening the path to a coalition agreement at the national level. We maintain an overweight on Spain. Both nominal and inflation linked bonds stand to gain in the economic and political environment and in the face of ECB QE. France Nicholas Sarkozy’s centre-right, Union pour un Mouvement Populaire (UMP) party took 32% of the vote in the first round of regional elections. The far-right National Front (FN) party captured 25% of the vote, less than had been feared. The left will likely lose local seats, but the euro-sceptic party gains were not as great as expected. We remain underweight French risk, but see value in the 10yr – 30yr curve flattening trade. 3 Our base case remains unchanged, with an agreement on the austerity program being reached, perhaps at the last minute. In the event no agreement is reached, ECB support should limit systematic risk, and cushion the initial impact on the markets. Deposits do continue to flow out of the banking sector, by some estimates at levels of between 2 billion and 3 billion euros per week. Should this continue, a major short term risk would be that capital controls could be put in place to stem outflows. The Netherlands In reality, economic growth in the US recovery has moderated somewhat, impacted partially by the strong dollar and weakening export performance. Growth has fallen to around 2%. Softness in the non-accelerating inflation rate of unemployment (NAIRU) which dropped from 5.35 to 5.1, indicated that there is more slack in the economy than had previously been anticipated. The senate composition in the Netherlands has been altered to favour the centrist Democraten 66 (D66) Party and the Socialistische Partij (SP), who were the biggest gainers. This came at the expense of the Labor and Liberal parties supporting the government. While the gains of the euro-sceptic Partij voor de Vrijheid (Party for Freedom – PVV) were lower than expected, it is likely that passing legislation will be even more difficult for the government going forward. USA: The FED has spoken, so what was said? All ears have been tuned to the Federal Reserve (FED), however, when she spoke, Janet Yellen was not yelling. The message was more nuanced than had been expected. The market had eagerly anticipated the removal of the word, ‘patient,’ in Yellen’s statement, signalling a more hawkish stance and near term Federal Funds Rate (FFR) hikes. It was the doves who had their day, when the remark was made, “just because we removed the word, ‘patient,’ from the statement, that doesn’t mean we are going to be impatient.” The FED remains protective of the economic recovery and the Committee has indicated that normalization of target FFR will commence when further improvement in the labour market is seen, and the Committee is, “reasonably confident,” that inflation will trend back toward its 2% objective over the near term. Our Assessment: We expect the majority of the FOMC to become “reasonably confident” during the 3rd quarter of 2105, and anticipate gradual and cautious normalization thereafter. Preconditions for the rate lift-off are as follows: l Further improvement in the labour market l No decline in wage growth Fixed Income l No decline in core inflation Key Rate & Policy Objectives l No noticeable decline in survey- based and market-based inflation expectations Two rate hikes this year appear reasonable to us, in analysing these key rate and policy objectives, and as are implied by the FED ‘dot charts. (See attached). When tightening begins, a smooth path of rate increases should not be expected, as the FED should remain sensitive to external shocks going forward. In longer duration, the liquidity effect of Eurozone QE, with the 10yr Bund rate declining to 0.17% may also serve to thwart the pace of rising 10yr US rates as investors look to capture higher returns. Federal Reserve Dot Chart We expect money market rates to edge higher over the course of the year and have a preference for greater than one year floaters over fixed rate bonds. Japan and Emerging Markets In Japan, despite the large monetary stimulus by the BOJ, economy continues to see negative effects, and prospects for growth remain limited. The flash March estimate of manufacturing PMI showed signs of weakness, dropping from 51.6 to 50.4, calling into question the sustainability of the recent surge in industrial production. China, too, saw a March Markit HSBC PMI reading that came in below consensus expectations of 50.5, printing at 49.2, which was down from February’s 50.7 reading. While weaker growth momentum has caused GDP targets to be revised downward, Asian economies, and China’s, in particular, remain at the lead of emerging markets growing economies. 4 Source Federal Reserve Board of Governors (March 2015) Russia 7,5% 31/03/30 Source Bloomberg as of 10/04/15 Fixed Income Russia’s Central Bank has been injecting liquidity into the banking sector via a $50bn FX REPO facility, creating a cheap source of FX liquidity for banks lacking access to external markets. At the end of Q115, the $31bn of the facility had been utilized. Banks have been using this facility to finance carry trades, rather than passing on liquidity for lending, limiting the follow through impact this facility was meant to provide for the economy. In market terms, however, this has created a technical demand for Russia’s 15 year government bonds, causing yields to fall by 280bps year to date. (See graph) We view this move as a technical distortion, and at current yields, assets are vulnerable to downward price movements. Currencies: Monetary Policy diversion supports the USD and GBP The more dovish stance of the FED has pushed back the likelihood of rate hikes to the second half of the year, triggering a near term and overdue correction in USD strength. In our view, this is not a game changer for the underlying fundamental story. Monetary policy divergence should continue to be the biggest driver, as investments should continue to trend out of the Eurozone toward countries with more hawkish monetary policies and better growth, such as the US and UK. Lower oil prices should continue to dampen inflation in Japan, putting pressure on the BoJ to provide liquidity to achieve inflation targets. In addition, Government Pension Investment Fund (GPIF) allocation targets have been altered to favour further investment in foreign assets, yielding an increase in capital outflows. JPY should remain under pressure, as a result. 5 Credit Investment Grade Solid credit fundamentals coupled together with the QE, remain supportive of IG corporates and financials. Money continues to flow into high grade funds, with nearly $13bn in inflows to the asset class from the retail side, year to date. New issuance is running slightly ahead of demand with €87.2bn of new paper being brought to market through 24 March 2015, eclipsing last year’s issuance by €36bn at this stage. US corporates, taking advantage of lower yields, continue to tap the European market, making up more than 20% of European issuance year to date. A heavy issuance calendar has led to recent spread widening, however, given low Bund yields, spreads should rally as the overhang is digested. High Yield Credit quality within the European high yield market remains satisfactory, though there has been some decrease in free cash flow generation in single B-rated issuers. HY fund flows have been positive, and the market is open for first time issuers with more aggressive financial profiles. Ratings for newly rated issuers have declined slightly while leverage has risen. ECB QE and the lack of available yield elsewhere continue to be supportive technical drivers for higher yielding markets. Glossary Breakeven: Euribor: Money market: See inflation expectations. Benchmark money-market rate for terms ranging from one week to two years. Cash market. Banks place their short-term cash on this market or go to it to borrow the funds they need on a short-term basis. See also Eonia, Euribor, overnight rate. Bund: German Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Covered bond: A bond issued by a bank and this is backed by collateral, or a guarantee, most often mortgage loans. Duration: Average life span of a bond or a bond portfolio, including all related flows, i.e., coupons and partial or full repayments. The more a 10-year bond pays out high coupons and makes partial repayments, the shorter its duration. The lower its coupons and the closer its repayments are to maturity, the longer, or higher, its duration. Haircut: A haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral. The size of the haircut reflects the perceived risk associated with holding the asset. Inflation expectation: This is the spread between the bond market yield on a certain duration and the real rate (ex-inflation) as results from the market value of a bond linked to inflation of the same duration. Inflation-linked bond: Eonia (Euro OverNight Interest Average): Bond whose principal is indexed regularly to inflation of the issuing country or the euro zone. The remuneration rate, which is based on the principle plus inflation, therefore offers a real remuneration (ex-inflation). Average euro zone overnight (see this term) money-market rate. Investment approach: Overnight rate: Refers to a 24-hour loan that may be rolled over indefinitely. OAT: French Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Spread: The difference in yield between two bonds with the same maturity, with the former often offering greater risk than the latter. Treasuries: US Treasury bonds. Unless otherwise indicated, with a residual life of 10 years. Variable: See investment approach. In each region (US, euro zone, and emerging markets) we review the following variables over the medium and long term: growth potential, inflation risk, monetary policy, long bond yield potential, and risk appetite. All data provided in this document come from the following sources: Datastream, Reuters, Boursorama. The variation listed are calculated from one month to the other. 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