Macro and ECB
- Growth prospects: a mild recession represents a bullish scenario. Hard and soft data point to a less severe-than-expected downturn. Market-based financial conditions continue to “adjust” to central banks’ tightening strategy, but do not seem to be entering into “dangerous territory”. The conditions faced by the real economy may become more relevant ahead (although it does not seem to represent an overwhelming generalised threat so far).
- Inflation: the focus is clearly shifting from headline (now peaking mostly due to energy costs) to core (more resilient). Even assuming that the headline inflation may have peaked and could print an (occasionally sharp) moderation in the months ahead the issue with inflation is far from resolved. Core inflation (lagging headline) is now the main focal point (very likely standing above 4.5% YoY by end-2023).
- The ECB strategy: There could be c.50/100bp of room for Deposit facility (real) rate to become fully restrictive: this will most likely be achieved through the nominal depo rate raise (around 3.00% / 3.25% by end 1H23) with more stable inflation expectation dynamics. Looking further ahead, we see more of a plateau than a hump in the ECB’s rates path.
- Regarding the QT, we expect the ECB to increase the roll-off volumes in 2H23 to an average of EUR20bn/month or even EUR25bn (c.EUR190-200bn in FY23, c.150bn in PSPP). EUR550bn of TLTRO III will redeem in June and c.EUR817bn in FY2023 as a whole. In any case excess liquidity will still stand at around EUR2.8trn by the end of 2023.
Rates strategy
- We believe that there is room left for further upward adjustment in real rates. We still expect Bund yields to stand at around or somewhere above 2.70% in 2H23 (3.20% for 10Y swap).
- What may have been be delaying (but definitely not disrupting) the natural upward adjustment in (real) rates? i) Flows exiting bank deposits may represent a new demand factor for (some) fixed income securities; ii) The decoupling of the PBOC & BoJ with the rest of central bank’s approach to liquidity injection should gradually disappear mainly in what regards BoJ as PBOC strategy still features high degree of uncertainty (timing, direction, intensity)
- Slopes: the only way is up… but who’s the driver? Within a 12 months perspective we a foresee a moderate steepening bias related to the foreseeable end of the rate rising cycle (but not necessarily a soon-to-come reversion) combined with the impact of the QT.
- What area of the curve will revert first and by how much? i) the exhaustion of the short-term rates uptick should allow 2/5Y and 2/10Y slopes to revert upwards (although not imminently). On its side some structural factors (market positioning flows) may continue to hamper/limit the steepening bias in the ultra-long areas of the curves.
- Asset swaps are still reversion mode towards their fair value: further compression is foreseeable but the timing will depend on QT being geared up.
Peripherals strategy
- Peripheral spreads: we expect higher spreads in 1H23 compared with current market prices, due to supply activity, the unwinding of carry positions on June’s TLTRO, and the monetary policy tightening cycle that is still in place. Later in the year, if the cyclical outlook proves to be less severe, it would lead to a more benign scenario for real rates. Tenors up to 10Y may well then perform better than the longer tenors. The main drivers for market movements will be:
- From a growth perspective, the main risks in 2023 are associated with global factors: i) an escalation of the Russia-Ukraine war (and geopolitical tensions in general); and ii) a downturn in the US economy. Given: i) the increasing diversification in the energy supply channel in Europe; ii) the already existing EU-common funding mechanisms; iii) the role of the RRF plans in boosting (particularly peripheral) economies; and iv) a much higher exposure to the war scenario for northern EU countries, we do not believe peripherals will suffer more than core countries.
- Considering the structurally different (and lower) level of the Bund’s richness, the almost 50bp lower Bund vs. the 10Y €-swap spread with respect to the peak seen in October should be almost fully reflected in the peripherals-Bund spreads (e.g., all else being equal, the October peak in the BTP-Bund spread at 260bp is now equivalent to c.210-215bp).
- We expect a conservative approach from rating agencies in the next few months, making it hard to see any further actions on the ratings front before 1H24 and in any case the main candidates would likely be in for a positive change in outlook.
- We do not see any major concerns about debt sustainability for peripheral countries, and even though market microstructure conditions are becoming more challenging, they are not disruptive at this stage: primary dealers are increasingly confident of being able to offer good liquidity conditions in this “new normal”.
- On the political side, while the national governments in Italy and Portugal have ample and solid majorities in parliament, in Spain there will be regional/local elections in May 2023, and general elections by YE23. In Italy, the new government’s first steps have signalled a prudent approach in terms of its fiscal stance and lower-than-expected confrontational risk with the European Commission.
- Supply/demand factors: in the “new normal” world, the dynamics of supply and demand flows are becoming an even more relevant driver.
- From the supply side: the gross issuance of peripherals in 2023 will be higher than the amounts sold in 2021-22. While for Portugal this is mainly due to an increase in net funding, for Italy and Spain the redemptions dynamic weighs more on the gross supply target.
- From the demand side: i) foreign investors’ current positioning suggests limited risks of relevant outflows on periherals; ii) for domestic banks, the current exposure to domestic public debt suggests there is still some room to raise these levels, especially if there is some friction in lending activity; iii) given the new context of high inflation and the real value of retail savings being eroded, the role of retail investors is of increasing importance in the peripherals market.
- Relative value: Italy looks comparatively more sensitive to core paper scarcity issues, particularly the 10Y tenor.
- SPGBs: peers, the Spanish credit curve in the 10Y-30Y area is steeper vs. Italy, with potentially more interest from investors in these maturities. 10Y target +85-100bp vs. the Bund.
- BTPs: we see the highest value for the Italian curve in the 5Y-10Y area (the Italian credit curve is much steeper than the Spanish and Portuguese curves). Moreover, in a context of high uncertainty about the ECB’s next steps, we suggest to look at CCTs-eu (floating rate bonds), which offer a not-negligible pick-up on BTP.
- PGBs: should benefit from a limited recourse to the market in absolute terms compared to Italy and Spain. The Portuguese 15Y area has recently come under more pressure than Spain and Italy, indicating where one can find some value in the Portugal curve.