2022/02/14

European peripheral sovereigns | Presentation: How to cope with the «tightening mode»

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European Macro and Sovereign Strategy Outlook:

The overall growth outlook remains promising enough: the gradual catch-up in the rate of activity is expected to continue in the next few quarters. The pace of this recovery may still be hampered in 1Q22 by the combination of Omicron/energy costs/supply bottlenecks, but broadly speaking the negative impact of these factors (mainly COVID-related) seems to be following the “law of diminishing returns”. Despite the uncertainty this creates, economic players already appear to have included this “margin of error” in their outlooks, and these sorts of headwinds now are now having less of an effect on confidence

ECB policy: the probability of a Deposit Facility rate hike in late 4Q22-1Q23 has increased significantly (although any view on this now looks very data dependant), and the main issue to be dealt with by the market now seems to be whether this will be preceded by a first rate hike in 2Q-3Q 2022 (not our base case); the tapering of the APP net purchases will very likely be brought forward (perhaps discontinued in 4Q22); iii) we expect the ECB to increase the tiering threshold from the current 6x, but this may not completely avoid some early repayments of TLTRO III and the ensuing reduction in excess liquidity in the system from June 2022

We are inclined to believe that there is some risk of overshooting in terms of the hawkish reaction shown by these curves (which is also being translated into the short tenors of the swap and govies curves

Swap and sovereign yields are definitely biased to the upside with the real rate component as the main drive We now see Bund yields approaching references around 0.40/0.50% in 2Q22 (0.80% for the 10Y swap) and testing levels around 0.60%-0.70% in 2H22 (1.00% for the 10Y swap). The 2Y area could increase further from current levels, albeit more moderately (references around 0.10% for Schatz and 0.50% for the 2Y swap for YE22)

Core-periphery spreads: we see the SPGB-DBR spread ranging at 75-110bp in 1H22 and 85-120bp in 2H22. BTPs’ high-beta nature will most likely lead it to underperform its peripheral peers: we see a 150-180bp range in 1H22 and some widening to 180-200bp in 2H22. We believe that PGB may lose the “lead” it has so far enjoyed vs. its peers: 75-100bp in 1H22 and 80-120bp in 2H22

Intra-curve strategy: the BTP curve is the most exposed and its spread could suffer more than its peripheral peers (high Beta). The 10Y area is strongly correlated with general movements in rates and the 7Y area has also been very reactive to upward moves. We believe PGBs offer limited room for improvement and low liquidity could lead them to underperform vs. SGPBs. SPGBs could outperform peripheral peers during the upward movements in rates

Strategy within the curve: For SPGBs we have a relatively positive view on the 10Y area vs. its peers as well as at the long end (compared to the rest of the year, issuance in this sector should remain low after the latest 30Y syndication). On PGB, the short end should continue to be anchored (as low liquidity and possibilities of buybacks should anchor its performance) while longer areas of the curve could suffer vs. SPGB.  As for BTPs, we prefer to maintain a cautious approach to the short end and belly of the curve and expect the long end to continue to outperform shorter areas of the curve

Regarding issuance, we believe that DMO will continue resorting to syndication activity as its financing needs and gross issuance targets will likely remain high – similar to last year. However, we believe it could have lower-duration issuance than in FY21 and that DMO could pause its strategy of increasing its average duration if yields keep rising

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