In the weeks to mid-March, the dominating theme was perhaps the return of decorrelation between risky assets and rates. All G4 sovereign issuers saw falls in their 10-year yields, while major equity indices all took hits. Credit spreads also widened.
Main Street has shrugged off rate hikes – but how much do central banks need to worry about Wall Street?
Much commentary has focused on the (perhaps surprising) resilience of economic growth and the labour market to the Fed’s and the ECB’s monetary tightening. While there is no guarantee that weakness won’t begin to appear, last week’s “run” on a regional US commercial bank left observers wondering about risks slumbering in financial institutions’ balance sheets. While first assumptions would suggest that in the face of rising rates, the biggest danger comes from non-performing loans as borrowers are unable to cover rising interest expenses, in this case it was investments in US treasuries that led to a reckoning: unrealised losses on treasuries had built up to such an extent that the bank has simply no liquidity left.. Although more stringently regulated than smaller American banks, Credit Suisse soon came under pressure. The Swiss bank, long a “problem child” among major European lenders, saw the pace of deposit outflows increase from a constant trickle to a stream – not quite a “run” yet, but enough to provoke worries about liquidity. This forced the hand of the Swiss National Bank, which publicly committed a liquidity line to stave off depositor worries.
For the March ECB Governing Council meeting, the central bank stuck to its announced 50 bps hike. A downside surprise from the ECB with a hike of only 25 bps was indeed unlikely, as Christine Lagarde had previously caveated her announcement that a 50 bps hike was “very likely” by saying that only an “extreme” event would compel the board to deviate from this plan of action. Therefore, the implicit acknowledgement that a lower hike or even no hike means we are in a crisis situation was seen as the worst of two bad options.
Central banks will need to think twice about action that increases the risk of excessively degrading financing conditions – which could exacerbate the risk of further contagion. Promoting financial system stability is an explicit objective of the Federal Reserve. In Europe, the ECB’s stated primary objective is price stability. Christine Lagarde stated that in the ECB’s view, there is no contradiction between financial stability and price stability. In all likelihood, we can interpret this statement as a reassurance to the European public. The ECB does acknowledge the need for proportionality in its decision-making – ultimately a cost-benefit analysis that includes the soundness of the financial system.
In any event, the ECB has evidently decided that not committing to future hikes is more prudent, as it will leave more room for manoeuvre in a volatile economic, political and financial environment. From now on, future hikes will be “data dependent”.
On the other side of the Atlantic, the expectations weighing on the Fed are less heavy – markets are pricing only a 25 bps hike and Jerome Powell has not committed himself to the same extent. While no hike would no doubt nonetheless be interpreted as a worrying signal, a stronger slowdown in inflation than in Europe and the Fed’s broader mandate could justify such a move without triggering excessive alarm bells. Our own expectation, however, remains that the Fed will hike again in March. Longer term, the implication of the SVB failure fallout is likely a lower “ceiling” in terms of how far the Fed is willing to go.
Treasuries look expensive after recent jumps
The turmoil resulting from the SVB collapse, ironically, led to a partial reversal of one of the very factors that led to it: Treasuries rallied in a flight to safety. At these levels, we do not feel comfortable being long US duration – indeed from a long-term fair value perspective, US rates now look richly valued. As we look at the current shape of the US yield curve, we expect that with solid headline economic figures and cooling inflation, a re-steepening should occur. While the extreme inversion we had seen recently has abated, the curve’s shape is still far from historical norms. We believe that a steepening bias can help portfolios profit from the end of the tightening cycle without taking a strong directional position as we expect the next few weeks to be marked by strong volatility.
EUR rates: We expect headline risk to be a major driver of moves
With fears on Credit Suisse having the potential to spread to the European banking sector, we have closed our long-held underweight stance on EUR duration to return to a neutral stance. Headlines and news flow are likely to be the dominant drivers behind market moves in the coming weeks, pushing economic and financial fundamentals into the background. We expect this to manifest in sharp two-way swings as markets oscillate between fear and relief. We also hold a steepening bias on the 10-30Y as we expect healthy macroeconomic data to push recession fears into the background.
A (possibly) more prudent Fed: Good for Emerging Market Debt?
With domestic news potentially capping the amount of future Fed funds rate increases, Emerging Market Central banks will face less pressure to front-run the Fed. All else being equal, this is another element that reconfirms our positive view on local currency debt in select markets. We have also not observed a material appreciation of the USD vs. most EM currencies. On the other hand, in hard currency, current risk premiums are not sufficiently compelling vs. US corporate credit. Only in the very lowest quality segment do we see wide spreads. We remain positive on Brazil in particular, but following a strong performance we are taking profit on our long position on Czech rates.
Credit: It’s not only about specific risk
The events of the last few weeks have demonstrated once again that selectivity in credit, including investment grade names, is key. Indeed, we held no exposure to Credit Suisse or US regional banks in our bond and money market funds. Any further turbulence will further accentuate this theme. Investors may be tempted to frame the current situation simply in terms of whether systemic contagion will occur. While undoubtedly this should be at the forefront of concerns, it may hide the fact that other firms are facing their own idiosyncratic risks.
European Investment Grade Credit still enjoys an attractive carry in the current context and historically. It is a good entry point on solid fundamental names. We have a preference for international companies as well as European banks with a strong retail franchise posting a strong business profile and solid fundamentals. We turn neutral on the Euro HY asset class based on improved valuations and we maintain a neutral view on euro Convertibles and wait for better entry point.
Currency views
We have closed our long AUD vs. NZD trade after the RBNZ has remained surprisingly hawkish following the recent flooding in the country. We prefer to buy certain EMFX vs USD as the Fed is less hawkish, which could favour carry trades in a soft-landing scenario.