Credit Market Daily #60 %author %

16-December-2022

Good Morning!

Yesterday we said we thought the ECB could go hard in its messaging to avoid walk backs and that is certainly what they did.

Mme. Lagarde has taken the bear market rally out the back and shot it, one in the face, one in the chest.

Rates will go higher and will need to persist at that higher rate, Europe will have a shallow and brief recession and market expectations of the terminal rate are too low, and we will start QT!

“On staff projections that embed and incoporporate the market expectations of the terminal rate do not certainly allow a retrun to the 2% target inflation that we have in a timely manner.
So, more needs to be done, and, as a result new market expectations will hopefully be embedded in staff projections which will indicate we can reach the two percent inflation target”
Mme. Lagarde 16-Dec-22

I will cover the BoE’s more balanced meeting in the next post.

In summary – CPI inflation data is rolling over – but Central Banks are going to be restrictive as long as it takes. More importantly, they will not let recessionary risks deter them.

Again another great set-up for market expectations vs. actual outcomes in the coming quarters.

With this comes increased volatility as markets try and interpret economic data, Central Bank speakers and earnings.

I think this still points to a bottoming of risk assets in H1, particularly Q1 where we have 2 months until the next round of rate decisions and confirmation that inflation is peaking and a better understanding of recessionary pressures.

What were the main takeaways from the ECB presser (video below)?

Inflation Higher, Growth Lower

First Inflation expectations were revised higher next year, +80 bps to 6.3% and the ECB expects it to remain above its 2% target in 2025 similar to the FED.

Importantly Lagarde mentioned that whilst she expects December to see further declines in inflation the subsequent readings will face upward pressure as energy price increases have yet to hit the retail channel.

Food and Energy prices continue to remain high, with wage inflation something the CB wishes to keep a lid on.

The ECB predicts a shallow and short “quarter recession starting in Q4’22 and ending Q1 ’23 with a return to growth supported by an expected easing of supply bottlenecks, robust jobs and an annualising of energy price increases.

Outlook Worsens

Food and Energy will remain important drivers in 2023, with an overall decline in inflation in 2023 expected

QT (Don’t forget the TLTRO)

The ECB added to its hawkish stance by announcing QT will start in March ’23 at a modest €15bn per month.

This is more an announcement of intention to shrink the balance sheet without being aggressive it amounts to not reinvesting half of €30bn debt that matures monthly. This will be recalibrated after the first quarter.

Over time this will reduce what has been a strong technical factor for European Investment Grade Credit. The ECB has transitioned from buyer of bonds to seller ’22 to ’23.

The second thing that this does, alongside the increase in rates will be to increase focus between the strong and weaker economies across Europe.

Add to this the cash that is being returned to the Central Bank via the TLTRO and there looks to be a reasonable attempt at right-sizing of liquidity by the ECB in the offing.

You can expect the spread differential between core and peripheral European corporates to increase.

The Italian BTP-Bund Spread is spiking up from recent lows and I think you can expect this to test recent wides again.

The ECB will no doubt have to come out with further detail on how they will manage/ameliorate the core-periphery spread from widening too much.

Credit

High Yield

Euro and US High Yield had a soft day on the back of their central bank and economic outlooks.

GBP High Yield was relatively flat on the day in total return terms.

GBP, EUR and USD spread moves were +8bps (Z+690 bps), -15 bps (Z+492 bps), +13 bps (Z+464 bps) respectively.

We suspect the spread move in EUR HY is an anomaly that will reverse.

Xover widened 32bps on the day to 469 bps and is opening up at 477 bps – inline with our 500bps target for Jan.

Leaders and Laggers

Investment Grade

European Investment Grade was the loser on the day, unsurprisingly given the move-in rates with the belly and tail underperforming the front end.

The 1-3 year bucket saw its yield increase to 3.85% from 3.68%, 17bps higher, whilst its Z spread declined c.-4bps.

Looking at the 5-7 year bucket yields increased from 3.98% to 4.14%, 16bps higher, whilst its Z spread declined-1bp.

Yesterday’s underperformance was limited to a movement in rates. The credit component should widen all else equal with the ECB’s call for a recession in Q4 ’22/Q1 ’23 as well as some giveback of the recent rally.

GBP Investment Grade outperformed and the more “dovish” stance from the BoE may help this continue near term given the reduced upward pressure on rates (2023’s additional Gilt supply will challenge this).

GBP, EUR and USD index spread moves were +0 bps (Z+193 bps), -2bps (Z+170 bps), +1 bp (Z+132 bps)

Rates

Gilt yields declined after the MPC, which showed members’ votes coalesce around a 50bps hike which was interpreted as dovish. There was no mention of market expectations perhaps a recognition that rates have moved lower after the November meeting.

European rates rose on the back of the ECB’s meeting with a flattening of curves/inversion with the increase in terminal rate expectations.

10-year Gilts, Bunds and Treasuries yield 329bps, +214bps and +348bps.

Equities

Equities were weak across the board yesterday down between c. -1% and -3.5% ( see table below) as equities digested the recessionary, hawkish central bank messaging.

This morning European and UK equities are opening down around -70bps. US futures are c. -1% and I would expect the weak risk tone to continue.

Today’s Events

Eco Data

Yesterday saw US retail sales come in weaker than expected at -0.6% MoM vs. -0.2% expected overall adding to the gloom following the FED meeting. Autos led the decline but overall the fall was broad-based across categories

UK consumer confidence improved from the lows to -42, from -44 and vs. -43 expected. This is a continued bottoming out from the lows of 49 seen in September. Really interested to see how this develops given the outlook for the UK economy and rates in the new year and the recent cold snap likely worsening the choice between heat and food.

Today’s Reporting

N/A

Credit Market Daily #60