Pulling the Punchbowl When the Espresso Is Hot and the Economy Is Cooling

By Heisenberg

You can count me skeptical when it comes to whether € credit is going to be able to accept the wind down of CSPP with relative alacrity.

I know some of my more sophisticated readers would tell me I’m preaching to the choir when I say that, but there’s still a sizable contingent out there that seems to think it’s somehow going to be possible to remove that ongoing bullish technical from a market that, broadly speaking, is priced to perfection without everyone suddenly deciding to take a closer look at whether they’re being compensated adequately for bearing credit risk.

I’ve obviously talked about this a ton in these pages, but I was thinking about it over the weekend in the context of Italy and I think one thing that’s worth considering is whether the potential exists for a kind of “double whammy” scenario where the relative weighting of Italian credits at the index level ends up causing problems at a time when spreads are set to lose the technical tailwind from CSPP.

I’m just going to excerpt the post in which I laid this out because I don’t want anyone to miss it in case it turns out to be some semblance of important later on down the road:

And see here’s where this gets really dicey. Italian debt isn’t exactly trivial in terms of its representation in the € IG and € HY markets:

ItalianShare

As detailed extensively here last Monday, key to keeping a lid on € credit spreads is successful forward guidance from the ECB. “Successful” just means keeping the market in the loop and not delivering anything that approximates a hawkish “surprise.” That effort is in the service of keeping rates volatility suppressed, as rates volatility is what will ultimately determine whether and to what extent € credit spreads blow out.

So the risk here is that thanks to Italy’s reasonably high representation in the € HY market and non-trivial representation in € IG, you could get a kind of double whammy effect if the ECB bungles the message. That is, if they inadvertently send an overly hawkish signal that causes rates volatility to pick up, that could weigh on credit spreads in two ways: through the market’s straightforward assessment that the end of APP is nigh and rate hikes are “quarters not years” away (to quote Villeroy) and also through a kind of second-order effect whereby folks start to question what the read-through for € credit as a whole is (given the representation shown in Charts 11 and 12 above) if the ECB is rolling back support for Italian assets just as the political situation clouds the outlook.

This was the same conversation folks were having last year in the run up to the French elections and it was an even bigger deal there given that at the time, there was something like €400 billion in French corporate debt out. That compares to roughly €110 billion of Italian IG and €48 billion of Italian HY as of earlier this year.

So while the sheer amount is smaller, we’re now closer to the end of CSPP than we were headed into the French elections. And again, I guess I wonder whether there’s some endogeneity going here, where CSPP is keeping € credit calm at a broader level and that calm is at least a little bit dependent upon periphery debt not reflecting political risk which is itself a function of CSPP’s influence.

If everyone is being honest, it’s impossible to answer the questions implicitly and explicitly posed above ahead of time.

There are of course reasons to be skeptical that anything too dramatic is in the cards. For one thing, there’s no guarantee that things have to go completely off the rails in Italy now that the populists are set to govern.

To be sure, it was the worst week for Italian bonds since 2015, and as Goldman wrote late last week, “the ‘search for yield‘ environment supported by the ECB conventional and unconventional policies and by ample global liquidity has contributed to market resilience, but an adverse political outcome could trigger a more extensive correction to the pricing of Italian assets.”

Italy10Y

But EMU breakup risk is near post-debt-crisis lows and the risk of contagion (i.e., a systemic spillover) is similarly low:

systemic

“The logic goes that if QE compressed risk premiums in credit and potentially too much then the end of QE must see risk premiums rise and revert back to their previous state,” BofAML wrote earlier this year, commenting on CSPP wind down before noting the following:

While we have sympathy for this view, we remain in two minds as to whether the end of QE will really be such a big risk-off event for the Euro credit market. If we are correct and the Asia buying story grows, then this combined with ECB corporate reinvestments might fill a chunk of the void left by Draghi in 2019.

Barclays picks up on the “it should be ok” theme in a note dated Friday. To wit:

Our economists expect the ECB to end its net asset purchases by the end of 2018, after a short taper in Q4. While this would signal the end of net-investment, it would not mean an end to the ECB’s presence in credit markets; reinvestment due to maturities and via the amortisation adjustment is likely to keep the ECB active in corporate bond markets until at least 2020.

In €IG, we struggle to identify a “CSPP premium” and hence see little reason for spreads to widen as the CSPP “ends”, though we would not be surprised if €-IG underperforms $- and £-IG into September. That said, we view current valuations as favouring decompression trades in €-IG given the scope for volatility to rise alongside idiosyncratic noise, and the end of the CSPP is a plausible catalyst for performance.

Still, credit markets reflected the uncertainty last week and you can see in the right pane (below) that spreads haven’t rallied with European equities which hit their highest since January this week (with the obvious exception of Italian stocks which, despite the recent turmoil, have performed well YTD):

IGEuro

Whatever the case, everything above is worth considering, especially in light of the deceleration in the European economy in Q1.

At the end of the day, the question is probably less about whether the worst case scenario will materialize and more about whether the ECB will at some point come across as “too” hawkish in the APP forward guidance and inadvertently cause a spike in rates vol. That would weigh on € credit and potentially open the door a scenario where a hard stop on APP in September is out of the question and even a taper to say, €10 billion/month, is seen as dangerous.

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Published by

Gary

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