ECB in full tightening mode: how much is too much?
- The overall macro outlook has deteriorated significantly over the last few months and a technical recession in late 2022/early 2023 now seems unavoidable. A key point of increasing importance is related to what the risk is of a longer-lasting downturn. Financial conditions faced by the real economy (mainly the most vulnerable sectors) may represent a more important risk element ahead.
- Inflation: will definitely remain well above acceptable levels in the short term, with little visibility on where the peak may be. Breakdown details suggest a pass-through effect to all components but with a clear heterogeneity in its intensity. As for second-round effects, these are tilted to the upside, although so far relatively contained. Regardless of the timing and speed of the correction in headline inflation after the peak (foreseeably at some point in the next six months?) core inflation may reflect some inertia and thus take some time before it effectively reverses.
- The ECB’s foreseeable strategy: we believe that the severe tightening strategy (and forward guidance) will remain in force until the end of the year: we expect at least 125bp of additional hikes in 2022. However, in 2023 the air may get thinner (a cyclical downturn combined with tightening financial conditions for the most vulnerable sectors) and a more cautious approach may be warranted: we would expect a pause in the tightening cycle (tentatively until after the summer) and we cannot ignore an eventual resumption of the tightening cycle late in 2023-2024 (dependent on the cycle and geopolitics).
- Liquidity management: the tightening cycle will have to contemplate the reduction of excess liquidity at some stage, but some mechanisms (offering deposits to non-banks, reverse repo programmes, issuance of short-term bills) look more feasible/convenient than others (changing TLTRO III conditions and quantitative tightening).
- Rates outlook: a less severe strategy by the ECB in the first part of 2023 may lead short-term euro rates to moderate in terms of the hawkishness currently reflected. In our view, the main driver for yields across-the-board in euro curves will respond more to the supply-demand balance and general liquidity shrinkage (both elements clearly less supportive for fixed income assets) and arguably less to inflation expectations (looking more toppish now). Should a long-lasting downturn/financial stress scenario be avoided, there could be some room for a further uptick in the mid- and long-term parts of the curves (the short tenors are arguably more anchored). Bund yields could take a pause in late 2022 early 2023, but will resume their upward adjustment, approaching references around 2.50% by mid-2023 (3.20/3.30% for the 10Y swap)
- Peripheral spreads: our base-case is that spreads will continue to test the upper bounds of recent ranges in a context that combines non negligible sources of uncertainty (macro and geopolitics), potential financial stress derived from central banks’ tightening mode and a general upward bias in real rates across sovereign and swap curves. The main sources of pertinent market movements will be:
- the high correlation between core rates upside and pressure in the credit component will probably be present in the near future given that in the short run speculation on the ECB tightening cycle will continue both on interest rate hikes and reduction in the excess of liquidity.
- Some relief in peripheral spreads may be seen if and when, as we expect, the ECB adopts a more cautious approach. As for the ECB’s backstop role, we now see a relatively low probability that this will have to be triggered (despite the room to the upside we are still expecting for yields in the mid to long term along the curves). Nonetheless, the mere “warning effect” is still likely to play out but this would work more as an instrument to limit to the spread widening rather than one that would push spreads to the downside
- however, in most of the scenarios we do not see any major concerns about debt sustainability for peripheral countries.
- Relative value: we believe BTPs may suffer more in the context of ECB tightening and increasing recession risk than other peripherals. Only in case of later ECB’s more cautious approach and a stronger European coordination to the crisis response will help Italy in relative value terms vs peers.
- SPGBs: vs. peers, we prefer the longer tenors expecting Spain will follow the flattening in the 10Y-30Y area already seen in Italy and Germany. We find value also in the 7Y sector vs 2Y and 10Y that may well perform in the event of a more moderate approach by the ECB. 10Y target +100-120bp vs. the Bund.
- BTPs: the widening vs. Bund and peers experienced during 2022 has mainly been driven by the reduction of ECB support (at which price will Italy find marginal buyers to cover the net supply needed in the next few years?). We think this price discovery process has already reached a fair level but given the market caution in relation to the macro-outlook and the approach of the new Italian Government to its fiscal stance, we do not believe the spread vs. Bund will deviate much from the current range of 230-260bp. Later in 1H23, even if the ECB moderates its tightening approach and with a more effective European response to the downturn of the economy, we do not see the spread falling below 210bp.
- PGBs: should benefit from a limited recourse to the market in absolute terms compared to Italy and Spain, a better credit outlook and limited idiosyncratic risks in the short run. For these reasons, the strong performance of the PGB that led it to consolidate below the SPGB could continue. Spread vs. Bund should remain in the 100-120bp range, and we expect a flattening of its 2Y-10Y vs. GER 2Y-10Y.
- Issuance: we expect limited syndication activity in 4Q22 given the already high level of funding reached with respect to corresponding target: only Italy may approach investors with a new BTP 20Y/USD Italy or through a retail-targeted BTP (BTP Italy or alternatively BTP Futura). As in past years, Italy may be also active in exercises of asset liabilities management in order to reduce its refinancing risk and to take advantage of specific bond dislocations.As for 2023, despite the perspective of mounting funding needs derived from the crisis-countering fiscal programmes, we do not expect a significant increase in net bond issuance as NGEU disbursements should help cover part of these funding needs (cash basis). The flipside may come from the ECB effect: as of now we contemplate roughly flat net purchase activity by the ECB next year, but some risk exists of a less supportive context should the ECB start tackling quantitative tightening (not yet our base-case scenario but worth considering). All in all, the net recourse to capital markets in 2023 will be higher than in 2022 and this should in itself represent one of the main drivers of the relative valuation of peripherals.