Tariffs reloaded: Don’t bet on escalate to de-escalate. We expect tariffs to be sticky, but there is a risk of escalation if other countries retaliate, as we have seen with China already. In our view, tariffs are unlikely to go away anytime soon. As indicated by the formula presented by the US government, the focus is on bilateral trade deficits in goods, not on tariffs imposed by other countries on US imports. The key risk is whether other countries retaliate, which could escalate into a full-scale trade war.
Tariffs raise the price of final and intermediate imported products, adversely affecting domestic consumers; raise the cost of investment in equipment and infrastructure; generally result in retaliation from other countries, which hurts exporters; and are associated with trade policy uncertainty, which causes businesses to delay capex investment and hiring. In the face of weaker growth in activity and employment, the unemployment rate tends to increase.
Attractive all-in yields, strong balance sheets, materially extended corporate liability profiles and still low default and delinquency rates all still mean something, in our view, and this is the reason why we do not see traditional recession levels in credit spreads, at least for now. The traditional credit market reaction function to a recession, if realised, means IG spreads potentially peaking below the 200bp-ish and HY at 900bp-ish, the levels we usually have in mind when pricing a textbook recession without a significant impact on the global financial system (i.e, during the GFC both US credit indices peaked at levels double those just mentioned).
However, it is clear that the left-hand tail of the risk distribution has become fatter and likely inhibits proactive risk-taking for now, with the risk of further bleeding. That is the reason why US IG spreads at 130-135bp (current level of 120bp, +25bp from 2024YE) and US HY at 450bp (from 385bp now, +100bp from 2024YE), which are still well below the previous recessionary levels, would be, for now and with many caveats, our base case scenario.
In EUR, we would expect spreads to widen up to the 135bp area in high grade (G-spread, 115bp now, 10bp wider compared to pre-German fiscal news) and 475bp in high yield (385bp now, G-spread). Strong private sector balance sheets and fiscal stimulus can somewhat cushion the impact of the trade war, and we’re not ready to fully price a recession in spreads, with the understanding that the market may overshoot these levels if outflows materialise over the coming weeks.
Covered Bonds: Supply to go up as primary markets will be extremely challenging for senior debt. In the first week of April alone, we have seen EUR6bn of EUR benchmark supply, which compares to a mere EUR9bn across all of March. We have closed the shortfall to last year’s run-rate to EUR20bn, having been behind by more than EUR30bn in mid-March. Despite the volatility in the market, all the deals from last week are 1-2bp tighter than reoffer levels.
Four factors will continue to support covered bond supply in the next weeks: a) Weakness in credit markets with senior preferred levels widening, b) Stability/widening in Bund-ASW spreads and hence stability/tightening on the SSA side., c) Successful covered bond transactions drawing in more issuers and d) relative share of ESG deals to increase.
The current market backdrop is certainly favourable for more covered bond supply. With widening Bund-ASW spreads (i.e, Bunds consistently outperforming swaps for the first time since April-May 2023) and the 10Y Bund-swap widening to -2bp from levels of -17bp merely two weeks ago, and covered bond spreads just wide enough vs. SSAs, new issues will continue to attract rates buyers in addition to credit buyers seeking a safe haven. With April 2024 relatively subdued in terms of supply, we may well continue to close the gap to last year’s run rate in the coming weeks.
1Q25 SSA supply in line with estimates despite the volatile markets in the EUR and USD space, SSA benchmark supply has been broadly stable in 1Q25 vs 1Q24. EUR issuance of EUR170bn, USD100bn and GBP222bn. However, there have been some fairly large differences across sectors and issuers. The EU (+9bn YoY) and German Lander (+8bn YoY) have stood out with more supply in EUR, against less supply from KFW, CADES, the Canadian provinces or Dutch agencies. For an issuer like the EU, this was clearly due to the higher supply outlook in 1H25 (and for FY25). Regarding the latter, lower 1Q25 issuance is a reflection of lower overall full-year 2025 funding needs. The EU will remain the dominant force in the EUR primary market with another EUR45bn in 2Q.
Regarding USD supply, we note the higher activity coming from non-European supras (+USD10bn) and IBRD in particular (+USD6bn YoY with two big USD6bn 7Y and 5Y benchmarks). Meanwhile, other sectors have been less active overall, driven by KFW (-USD6bn), European supras or Canadian agencies (-USD3.5bn for EDC for example).
Rather than widen vs. swaps as has been the case for credit, core SSAs, such as KFW, further tighten from their wides in March. KFW 10Y tightened from more than MS+40bp in March all the way to MS+33bp, while at the same time it is back to the high 20s against Bunds after flirting with the low-20s in mid-March. The German Bundesländer region (SSHOL) priced a 10Y deal the day after the announcement of the tariffs at asw+43bp, the same level as Hesse the week before, so unchanged in terms of pricing vs. the tariff announcement, highlighting the resilient performance of the SSA segment.