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“In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes. “
– FOMC Statement, 30th January 2019
- Reduced interest in risk-on positioning after recent rally
- Adopted tactical directional positioning in rates, amidst fall in volatility
- Strategic focus on curve trades in the US and Europe, with a focus on flatteners
- Short Italian debt and continued preference for USD weakness
- Strategically positioned for credit spread widening via European IG and US HY
- Increased interest in Additional Tier 1 banks
- Favour short and intermediate maturities, avoid generic/lumpy issuers in the BBB space
- Continued lack of attractive single-name opportunities in credit = increased cash
Macro: It is not the intention of our monthly commentary to start each time with a quote from a Fed statement. Recent months, however, had many investors turn into more avid Fed-watchers than usual, including us. The communication mishaps and subsequent forced shift to a more dovish stance have been remarkable, and worthy of our focus. Market behaviour so far in early February would suggest the troubles of the past quarter have been forgotten, with the VIX spot price trading at levels last seen before the global equity sell-off started in early October 2018. Indeed, volatility across macro-driven markets has collapsed in January, further supporting the rebound in risk markets globally. (Chart1)
Generally better-than-expected economic data have proven many recession fears to be premature. Both the Bank of Japan and the ECB are anticipated to continue their current monetary policy stance, with the latter expected to conduct further liquidity injections through TLTROs. Meanwhile, China’s slowdown has likely seen a bottom for the short-term, with further credit easing measures likely to support demand. This reflationary impulse combined with the lack of additional political noise on trade negotiations and Brexit helped to further bolster risk appetite.
We view the recent adjustment of risk markets, responding to more dovish Fed rhetoric, as now priced in. As a result, it makes us less enthusiastic about the attractiveness of risk asset beta compared to the beginning of the year. In the absence of any further communication turnaround, however, risk markets have likely got a bit further to run, as the hunt for carry intensifies – but the risk/reward payoff looks less appealing to us.
We expect further rate hike normalisation by the Fed, with the self-inflicted pause pushing out our call for the target rate to reach 3% by a quarter, to Q3 this year. The continued investment focus moves to those central banks where we foresee shifts in policy, especially the ECB. Sub-trend macro performance has left the ECB little room to manoeuvre. Its negative interest rate policy, however, is increasing pressure on bank profitability and subsequently its main monetary transition mechanism (Chart 3). We think some depo/refi rate adjustments are likely in the months ahead.
Macro positioning summary:
- Given the fall in rates volatility, we move our focus toward more tactical directional positioning over the coming few months and prefer yield curve trades to express our medium-term views.
- We continue to focus our macro themes and positions around the front-ends in the US and European bond market while preferring Inflation-linked to nominal bonds.
- We are shorting Italian bonds as we anticipate continued political tensions and calls for fiscal expansion to weigh on peripheral risk sentiment.
- We maintain a negative view on the US Dollar vs. selected EM currencies and the JPY
Credit: The Fed’s dovishness was immediately felt in credit markets as a strong rally took hold, leading HY segments in the US and Europe to not only recoup their year-end losses, but add 2-3% of additional performance. US HY rose over 5% during the month, putting it back in a precarious position from a valuation perspective, with an average yield back inside of 7%. A dovish leaning Fed, however, has potentially positive repercussions for the relative attraction of credit, as it puts a lid on the prospect for higher near term yields in the treasury market.
Corporate refinancing demands are set to be important drivers of credit market mechanics in the next 24 months, and if central banks resume their tightening mode there is a buyer of last resort to be replaced. That said, issuers have not yet responded to the optimistic tone to the start of the year and the much-feared flood of refinancing is yet to surface. In the absence of primary market supply, cautiously-positioned investors are at the mercy of secondary market inventory to fill gaps in their portfolios, which can lead to an overshooting in relief rallies.
We reiterate that credit fundamentals are uninspiring; European corporate behaviour is increasingly weighed on by an ageing cycle (leverage, interest cover), whereas US corporate fundamentals are actively deteriorating from a solid position, in the later stages of an already-extended cycle.
We are alive to short-term trading opportunities, while remaining negative on credit beta. Alongside other risk markets, Fed dovishness could lead to some further spread performance, although strategically we still see wider spreads on the horizon. We are braced for the possibility that strong data may take us back to where we were in Q4 2018.
Credit Positioning Summary:
- With a medium-term view that spreads will widen, but not significantly so, we move some of our short bias to European IG as we deem yield compensation to be too low to protect against spread widening, while European HY might attract buyers in the short term, especially if political headwinds dissipate.
- We like Additional Tier 1 Banks versus US HY. In single names, the market continues to show us that selection is important.
- We expect blow-ups to occur more frequently as firms deal with turning economic cycles, tighter refinancing conditions and less sympathetic trading conditions.
- Lastly, a softer outlook for the USD will favour our top-down consideration for EM credit.
Chart 9 – Liquidity challenges present a “known known” risk for credit markets. This chart was posted on social media and comes courtesy of DB’s expert research. This story has been around the block and doesn’t get any prettier. However, fragile dealer depth also means that unwarranted spread moves can appear on somewhat inconsequential flows, and this creates opportunities as well.
Chart 10 – We are comfortable with European bank fundamentals and see entry points into Additional Tier 1 bonds on the horizon. The AT1 space remains an orphan, with no discernible natural buyer and concerns around whether first call dates will be honoured in 2019 and 2020 will bring about volatility in the space.