GLOBAL CREDIT BULLETS | Monday, 20th June 2022

ECB – A line in the sand.
Last week, the European Central Bank called an emergency meeting to discuss measures to contain sovereign spreads. In 2021, expectations of monetary tightening pushed the BTP-bund spread wider by more than 100bp, to reach 250bp last week ahead of the meeting. The ECB thus turned worried about “fragmentation”, that is the possibility that financial conditions tighten faster in some countries than others. The emergency meeting did not bring any new policy measures. The central bank signaled PEPP re-investments will be used to re-balance purchases from core to periphery countries, and hinted at a new “anti-spread tool” in the making, to be introduced in case a more acute crisis kicks in. Details on the new instrument are still lacking. PEPP re-investments are in the order of EUR 100 bn for the next twelve months. So, in theory the amount is not small. Still, re-investments can be moved from one country to another only temporarily, to avoid expanding the balance sheet in tightening times and to respect capital key requirements. So a more permanent stabilization of spreads would require more details on the new tool, at least in absence of a more political approach to the spread problem. For now, the European Central Bank has just drawn a “line in the sand” at 250bp level of spread, without giving out much on how to keep the spread below this level longer term. Markets are likely to give ECB the benefit of the doubt over the next few months, especially given the strong track record in defending the periphery. Longer term, rising policy rates and upside pressure on bunds suggest markets may hit at periphery again. The ECB will thus need to give more details soon, or markets will end up testing the line again.

Fed – As hawkish as it could.
The Fed surprised markets with a 75bp hike, in line with what leaked out on Monday last week. The market was pricing 50bp until the Friday before the meeting, but higher than expected May inflation pushed the central bank to hike three quarters of a point. New projections and guidance came out hawkish too. The terminal rate was revised higher to 3.8%, up from just above 2.5% in March. The Fed now forecasts to achieve the terminal rate in 2023, despite inflation forecasts for 2023 and 2024 being left broadly unchanged. Also, 2022 growth has been revised down by almost 90bp following weakening data in April and May. High policy rates projections despite weakening growth underscore the hawkish stance. Unchanged inflation projections for next year suggest upside risks to the terminal rate, as a revision higher at future meetings may come with additional hikes penciled down. The Fed left the door open for another 75bp hike in July, though underscoring that 75bp increases are not the new normal. Rates markets continued to be well priced for this outcome, with the curve now pricing 3.5% policy rate in 2022, and 4% reached by mid-2023. The key risk for US fixed income remains stronger inflation prints over the next few months, as global forecasters (and the Fed itself) still expect inflation to come down relatively quickly over the next few months. Stickier monthly inflation prints constitute an upside risk for the Fed terminal rate and for the long-end, as the curve remains flat due to low long-term inflation expectations and some chances of a recession this year. The Swiss National Bank and the Bank of England also came out hawkish last week. The SNB surprised markets with a 50bp hike and a lower emphasis on CHF weakness. The BOE hiked only 25bp but opened to larger hikes in August and September. The Bank of Japan remains the only dovish central bank, triggering some intensified market pressures, as emphasized by weaker currency and wider JGB futures.

Markets – A historical week.
Markets just went through a historical week, with strong rates and equity volatility triggering heavy losses in both fixed income and equity markets. Weaker data and hawkish central banks is triggering a re-pricing of both fundamentals and multiples, intensifying asset prices volatility. In other words, markets are pricing high chances of a recession and no room for central banks to help in that case. European credit spreads are at highs since the 2011 financial crisis, cyclical equities are approaching levels only seen before the Covid vaccine was introduced, and oil started re-tracing gains quickly. At the same time, upward pressure on the front-end of global curves continue, and 10y Treasuries flirted with 3.5% last week. Overall, we think recession fears are overdone. Economies are certainly in a slowdown, and energy supply restrictions are making the situation worse in Europe, but growth levels are far from recession. Our in-house models suggest the probability of a recession in the next 12 months is materially lower than financial markets price. We thus think it is a good time to start adding some risk gradually, especially in areas that suffered both from recession pricing and wider yields. We see value in selected high grade credits with low duration and solid fundamentals. In our view, terminal rates remain the key risk for markets (even after the recent re-pricing), more so than a proper recession.

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Algebris Investments’ Global Credit Team