Earlier today, when discussing the potential threat facing Italian bonds now that a “populist, anti-establishment” government consisting of the Five Star Movement and the League appears inevitable, we pointed out the elephant in the room, first highlighted by Citi last December, when the bank observed that the only net buyer of Italian bonds in recent years has been the ECB.
And, in previewing the inevitable (if perhaps temporary) end of the ECB’s QE, Citi said that it is “pretty likely that there will need to be an adjustment in prices” although it left one possible loophole: an “Operation Twist” conducted by the ECB to alleviate the pressure on the long end:
As our rates strategists have pointed out, the ECB could counteract this through an “Italian Operation Twist” (lengthening the maturity of their BTP holdings), but such a response might not come immediately, given the ECB’s reluctance to favour individual countries, unless associated with the conditionality that comes with an economic adjustment programme.
In a peculiar coincidence, earlier today Bank of America’s Barnaby Martin also touched upon the issue of a potential Operation Twist being conducted by the ECB, in the context of two things: i) the fading impact/influence of Draghi’s bond purchasing programs, first shown last week by another Bank of American, Michael Hartnett, and ii) whether or not the ECB’s QE will be done come January 2, 2019.
First, recall that as BofA CIO Michael Hartnett pointed out last week, there have been increasing indications that the European Central Bank’s bond purchases are having an progressively less pronounced impact, and YTD 2018, European junk bond spreads have actually widened by 67bps despite €70BN in QE by Draghi. This is the first time since the launch of the CSPP that European junk bond spreads have widened despite continuous liquidity injections.
Second, consider that – as BofA’s European credit strategist Barnaby Martin writes – last week’s surprisingly low Euro Area inflation number raises the specter of core inflation ending 2018 at lower levels than in January. If so, “the onus may be on the ECB to get creative with their monetary policy in ‘19. “
Martin here reminds us that at the last ECB meeting, Draghi made an interesting reference to the bank “adapting” its monetary policy accommodation should financial conditions tighten, prompting the credit strategist to “wonder whether this is a subtle reference to the possibility of an “Operation Twist”.
So first Citi, now BofA.
As a reminder, an “Operation Twist” in Europe is the idea that the ECB could invest the proceeds from maturing bonds into longer-dated securities. Thus, by flattening the yield curve in Europe, the ECB would ensure an effective transmission of monetary policy in 2019.
Several weeks ago, Martin argued that “an Operation Twist would be quite powerful in flattening the credit curve, simply because of the relative shortage of longer-dated corporate bonds in Europe. In particular, we showed that it could work very well for flattening peripheral credit curves.”
So now that everyone is talking about “Operation Twist” in Europe, Martin looks at where the impact of an “Operation Twist” would be greatest in credit. He finds that consumer cyclicals and basic material names have the most shortage in the long end, as well as the lower rated part of IG credit (BBB flat and below). We also include a table of Eurozone non-financial names with liquid debt outstanding on the 10y+ maturities.
But what if instead of engaging in the complex contortions of an “Operation Twist”, the ECB simply maintains its CSPP program even as its stops purchasing sovereign debt? Martin responds:
We can see the logic with this argument, especially in light of the above charts. The evidence on the credit cycle looks mixed at this point. Moreover, keeping a “trickle” of corporate bond buying going in 2019 would cement the ECB’s forward guidance, as Draghi has stated that rates will only rise well after the end of net asset purchases. The bank remains far from reaching scarcity problems: the ECB holds less than 20% of the overall eligible credit market, against a possible upper limit of 70%.
Maybe, but probably not, because come 2019 it may become politically impossible for Draghi to continue.
Which is why ultimately Martin says he “sides with our economists, who make the very relevant point that there would be a big consistency problem for Draghi if the ECB opted for a “pick and choose” QE in 2019. At the very least, we think it would expose them to criticism about stoking asset bubbles, as the market would suddenly assume that CSPP would be endless.”
And so the BofAML base case is that “all of the various asset buying programmes by the ECB will draw to a close at the end of this year.”
Which brings us to….
January 2, 2019: Back to Basics
As Martin concludes, Jan 2nd 2019 – the first trading day of the coming year, could be the first day in years that credit markets will have to exist without the helping hand of net asset buying from the central bank.
As such, many of the things that have been conveniently forgotten will likely come back into focus. One such concept is spreads versus fundamentals. Does the market look tight relative to certain metrics? And what macro variables will the credit market be most sensitive to next year?
And since an entire generation of traders has grown up in a world in which fundamentals did not matter, below the BofA strategist regresses high grade non-financial spreads against a number of macro and fundamental indicators:
- Euro area GDP yoy growth, Euro area unemployment rate,
- the 10y risk free rate (bund),
- European equities earnings growth,
- median net debt to EBITDA of IG corporates, and
- defaults of euro high yield.
And while correlations differ, of course, as some metrics are more predictive for spreads than others (and QE has distorted some relationships over time), Nonetheless Martin is convinced that all measures are revealing.
So here’s what to keep an eye on…
With the focus set to shift away from ECB money flow and toward valuations relative to fundamental metrics, BofA finds that spreads look fairly valued versus European default rates and earnings growth, and look a bit cheap versus GDP growth, but that they look tight versus the unemployment rate. A summary of findings below:
- Spreads look “fairly valued” at this stage versus European earnings growth and European HY default rates. Movements in these variables should not have an outsized effect on credit spreads therefore.
- Spreads actually look a bit cheap though versus the level of GDP growth in the Eurozone. This suggests that the credit market could fare ok should the economy lose momentum quicker than feared.
- On the other hand, spreads look a little tight versus the unemployment rate across the Eurozone. This is probably because QE has worked very quickly on spreads but the feed-though to lower Eurozone unemployment has been very slow. Nonetheless, should the labour market in Europe lose steam, spreads could be vulnerable.
- Finally, what about credit spreads versus corporate leverage? The relationship is inverse and not so obvious at first. But it highlights the reality that in the European market companies have only increased their leverage when spreads were low enough to enable much cheaper refinancing relative to before.
Finally, the ECB’s participation in primary deals has ensured that new issue spreads have not jumped on the back of the increase in leverage.
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