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In the euro area, the new 10y benchmark
Bund is trading about 0.32%. Spreads in
sovereign bond markets changed little last
week. The downgrade in Italy’s rating by
DBRS caused modest BTP underperformance.
Portugal spreads has decreased (357bps)
following a successful 10y bond syndication.
Spreads on Spain’s Bonos have declined to
the 110bp area.
Euro IG credit markets offer average spreads
of 122bps, unchanged from a week ago. High
yield premia are about 356bps after a 23bp
rally year-to-date. Emerging debt markets
continue to be underpinned by the search for
yield. Spreads (325bps) are close to last
year’s tights. Brazil’s Central Bank lowered its
Selic rate by fully 75bps to 13%. The Brazilian
real appreciated initially before drifting back
above the 3.20 threshold against the US
dollar.
Lastly, sterling plunged to $1.20. Theresa May
is pressed to unveil her hand and define
priorities in the negotiations with EU after
Article 50 is triggered in March. The Japanese
yen keeps rising with a 1.8% gain last week
vs. the greenback.
Robust US consumption
Growth in the US was likely about 2.5%qoqa in
the three months to December 2016. Personal
consumption remains the main growth driver.
Consumer credit increased $24bn in November,
the largest gain since August. Retail sales rose
6.6%qoqa in the fourth quarter. AS a
consequence, the trade deficit widened again
and may subtract up to 1pp off 4Q16 GDP.
Investment in capital equipment appears to be
improving. Rebound in structure spending is
underway signaling a brighter picture for
overall investment.
Inflation (headline CPI) will stand above 2% in
December for the first time since July 2014.
The negative contribution from imported good
prices has reversed course on the back of
higher energy prices. The Fed’s narrative of the
inflation backdrop will likely evolve in the
coming months for fundamental reasons
instead of oil price gyrations. Unit labor costs
rose at a 3.6%yoy clip in 3Q16 in US
manufacturing. Since 1988, labor compensation
closely tracked growth in hourly productivity.
Annual changes in unit labor costs averaged
just 0.15% over this period. In the US economy
as a whole, unit labor costs are up some 3%
from a year ago. The uptrend in production
costs represents the real risk to price stability
in the medium run. Furthermore, fiscal policy is
likely to be eased substantially under the next
Administration. Public infrastructure investment
spending and promised tax cuts will support
domestic demand growth. The corporate
income tax reform includes protectionist
features that have the potential to add to
(imported) inflation.
Against this background, Fed monetary policy
will become more restrictive in the coming
year. The monetary cycle will depend closely on
the magnitude of fiscal stimulus and risks to
price stability. Janet Yellen will update Fed
Funds rate projections in keeping with the
above-mentioned elements in March. The FOMC
foresees two to four rate hikes in 2017.
Markets only price in one to two increases.
In the euro area, The ECB will meet this
week. Mario Draghi will not change its
communication despite a sharp rise in
inflation in December to 1.1%yoy. Growth is
also strengthening according to surveys.
Lean towards higher Bund yields
The ECB’s letter authorizing PSPP purchases
of securities yielding less than the deposit
rate has been signed by Mario Draghi. Such
purchases likely started last Friday 13
January. In the wake of the press release,
30y Bund yields increased breaking above the
1% threshold. Demand for the new Jan27
benchmark Bund had been strong at auction.
About 0.30%, 10y Bund yields seem in line
with fair value, which we estimate at 0.29%.
Moderate long duration positioning of final
investors seems no obstacle to a resumption
of the trend for higher euro yields in keeping
with faster inflation. The ECB is, in fact, the
main buyer in sovereign bond markets. On
technical grounds, the 0.31% level may be
pivotal for market participants. If yields break
above 0.37%, the next target may be 0.55%.
Downside references stand at 0.22% and
0.12%. We opt for a short stance in Bunds.
The market environment may be conducive of
further steepening on a one’s month horizon.
However, excess demand for Schatz/Bobl is
slowly being unwound after the year-end
squeeze. It is worth considering taking profits
on swap spread tighteners and move back to
neutral in 2-year and 5-year maturities. We
also recommend a tactical flattener on 2s10s
in the euro area.
US Treasury bond auctions (10y, 30y)
attracted great final investor demand last
week. Indirect bidders made up 70% of total
demand. Foreign central banks are again
adding to US bond holdings. T-notes issued
last Wednesday drew bid below 2.25%. In 30-
year maturity space, investors placed orders
at 2.75%. Fair value in 10y US yields stands
at 2.56% on our models. The unwinding of
short positioning by speculative accounts may
have maintained valuations below their fair
levels since the start of the year. We hold on
to a short duration stance on US bonds. A
break above 2.47% would entail a signal of a
continuation of an uptrend in yields towards
previous highs about 2.57-2.63%.
DBRS downgrades Italy
The rating agency cut Italy’s sovereign credit
rating one notch to BBBH. The downgrade has
no consequence in terms of PSPP-eligibility of
Italian debt securities. However, the lower
rating induces an increase in haircuts applied
on bond collateral posted by banks at the ECB.
Italian banks depend on ECB repo funding to
the tune of €205bn as at December 2016. For
example, the haircut applied to a 10-year
coupon bond issued by the Italian government
will increase from 3% to 11.5% after the
downgrade. The market reacted little to the
DBRS decision. Italian spreads remain close to
160bps. That being said, caution remains
warranted as Moody’s (Baa2, negative outlook)
is set to decide on Italy rating on February 10th.
In our opinion, Spanish Bonos offer more value
and stability albeit at a lower 110bp spread. We
hold on to our overexposure on Spain debt. The
spread on Portugal had suffered from
syndication rumors early on this year. The
transaction hit markets last week and was
indeed well received with 10-year Portugal
bonds pricing at 4.12%. The PGB spread curve
is nevertheless steep in part because of
diminishing PSPP support. In core markets,
spreads offer little value versus Bunds except
for 10-year French OATs and 30-year Belgian
OLOs.
Stability in credit spreads
Euro IG spreads are stable about 122bps vs
Bunds with only small differences in trends
across sectors. The asset class keeps attracting
investment flows as spread-for-rating levels are
better than on comparable sovereign bonds.
High yield is consolidating somewhat after a
strong start of year. Spreads, underpinned by
strong final demand, have come in to the tune
of 23bps year-to-date.
Emerging markets have proved resilient since
the beginning of the year. Spreads are holding
up at 325bps, in line with 2016 tightest levels.
Monetary easing (-75bps) was larger than
expected in Brazil. The observed fall in inflation
rate provides Central Bankers with some room
for manoeuver to support growth. Turkey is
under pressure given existing external
imbalances and a challenging political backdrop
to say the least. The Turkish lira lost fully 22%
against the US dollar since November.
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