ECB – Dovish Bark Doesn’t Bite.
The ECB Governing Council struck a relatively dovish tone last week as they communicated their intention to ‘significantly’ increase the pace of PEPP purchases in response to the recent bond market sell-off. However, there was no reference to increasing the size of the program and the ECB confined itself to a once-a-quarter adjustment to the pace of PEPP, giving itself less flexibility. Further, the governing council seem split as to how they will react should yields and spreads continue to widen. In short, the ECB delivered a weak message: step up the pace of purchases now, reassess in three months as function of the outlook. Overall, we think the ECB’s reaction function is still unclear, and the lack of clarity means it will be harder to lean against rising yields.
Credit flows – Time to open parachutes?
Flows pose an additional risk to credit. As Treasuries move wider, chances of outflows increase. Since the beginning of 2021, roughly half of all trading days saw net outflows in $ IG and HY credit ETFs, while $ EM saw outflows for a quarter of all days. As seen in the past, for example in 2018, outflows can occur suddenly, and aren’t particularly price sensitive. The worst single day of outflows year-to-date eroded almost one fifth of 2020’s full-year inflows for $ HY and EM, and 6% for $ IG. There remain plenty of inflows investors can withdraw into the bear-market, as cumulative inflows into the three ETFs were $45bn over the past five years. With tight credit valuations and potential further outflows ahead, we continue to hedge against downside in LQD, HYG and EMB.
Positioning – Adding to downside hedges.
With 10Y UST’s breaching 1.6%, we believe that risk assets have more downside. The moves down are led by US assets, where IG credit has twice the duration of the European benchmark and sold off ca. 5.5% YtD. To us, the market looks similar to 2018, where investors were long cash bonds, but lost money because hedges in derivatives didn’t work. The difference now, however, is that strong growth ahead offers opportunities in value equities and commodities, led by the reopening of the economy. In addition to our existing hedges and high cash levels, we look to add to idiosyncratic shorts in cash bonds with longer duration, low coupons and which are trading around par. In short, we look to short bonds which are pricing perfection, but which are in fact vulnerable. We also, add more protection in US cash credit ETFs, which match the actual bond selloff. Separately, we maintain upside in sectors linked to the economic reopening and reflation, through convertible debt and equity index options in financials, energy and travel.
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