Calamatta Cuschieri Weekly Commentaries-12 November 2012

There have been few market-moving developments in Europe recently over last week. The Spanish government as well as its European partners dropped further hints that a request for help might not materialize before year-end at least. Despite these comments, coupled with a short-lived “risk-off” environment, pressure on Spanish bonds remained limited. In fact, Spanish 10-year yields rose by 20bps this week, but are still range trading between 5.5%-6.0% since early September. Meanwhile, the Spanish Treasury issued a larger-than-expected EUR4.7bn of bonds on Thursday. It will likely continue to issue, despite having reached its 2012 gross bond target of EUR86bn, to prefund some of next year’s requirement. The focus in the coming weeks is more likely to be on the economy itself, as well as the finalization of the bank recapitalization program. The weak banks are well identified, and it seems that the quality banks are slowly regaining some market access, as evidenced by the EUR20bn drop in ECB borrowing by Spanish banks in October.

On the Greek side, the parliament has voted the necessary measures for the “troika” to go forward and eventually disburse the next tranche of help. At the same time, some debt relief is likely to be decided by end of November. General sentiment vis-à-vis Greece has improved remarkably from very low levels following chaotic elections and the realistic prospects of an exit from the euro area earlier this year. Until September, sentiment, most notably in Germany, increasingly suggested that a Greek exit from the euro area would be manageable and that it was becoming unavoidable, given the inability of Greek authorities to implement the programme. More favourable market trends had, in fact, already started in June. Interest rate spreads versus Germany have tightened and bonds prices doubled from their all-time lows, reaching their highest post-PSI levels so far. Statements by European and IMF officials have also been a new feature since September whilst Christine Lagarde, Managing Director of the IMF, made similar statements, along with other heads of states and governments. On the night of 7 November, parliament approved by a small majority the additional reform package requested by official lenders, and will gather again on Sunday, 11 November to vote on the 2013 Budget. Parliamentary approval on reforms and budget will enable the EFSF board of governors (in reality, the euro area finance ministers) to unlock the payment of the next tranche before the Greek government runs out of cash Meanwhile, the economic situation continues to worsen.

On the data front, the latest PMIs in the eurozone, factory orders and industrial production in Germany and business surveys in France are just some of a number of gloomy statistics pointing to a severe deterioration of economic conditions. Against this backdrop, fundamental factors increasingly favour a flight to quality causing yields on benchmark paper to fall slightly. Leading strategists retain the view that there is scope for a modest rally in the short term and a more pronounced move by the end of the year.

Meanwhile, in his latest press conference on 8 November, ECB’s Draghi kept all options open but did not strongly hint at a rate cut. On the one hand, it is clear that the ECB will have to cut its 2013 growth outlook further (likely from 0.4% to 0.1%, the growth forecast published by the European Commission over the past week). On the other hand, financing conditions have improved, and the effect of any refinancing rate cut is likely to be symbolic. It seems clear that the short end is likely to be stuck in a tight range for some time. This should also limit the volatility in 10-year and longer euro rates, which, to a certain extent, will continue to follow US rates.

US

With the status quo result in the US elections, the likelihood of hitting the fiscal cliff, at least temporarily, has increased. The best realistic scenario is a short-term extension of all expiring provisions. Even in this scenario, however, rates are unlikely to sell-off significantly, especially in the absence of market-moving developments in Europe. Now that the US elections have delivered a status quo result – Democrats keep the White House and the Senate, Republicans keep the House – attention should shift to the future of the fiscal cliff negotiations. Fixed income Investors are likely to stay in a holding pattern as they await clarity from Washington and given the lack of new developments in Europe.

The primary market focus seems likely to remain on US politics and the potential for a fiscal policy accident in the months to come. The most likely scenario is an eventual resolution of the ‘fiscal cliff’ that results in only a modest fiscal contraction in Q1 2013, it also seems likely that the resolution will create yet more anxiety and market volatility, as in the summer of 2011’s debate of the US debt limit. Another source of uncertainty during the election campaign was Fed Chairman Ben Bernanke’s likely replacement once his term expires in January 2014. Under a Romney administration, the replacement would likely have been more hawkish than Vice Chair Janet Yellen, who is a possible replacement under the current administration. Uncertainty about the continuity of the monetary policy framework has now subsided, with the chairman potentially being even more dovish in 2014.

In current market conditions, the Treasury curve is expected to continue to bull flatten as uncertainty surrounding the fiscal cliff negotiations linger, whilst term premium at the back end of the curve has not kept pace with the underperformance of risky assets. Meanwhile, bond yields declined by almost 20bp, as attention shifted to how the fiscal cliff might be resolved, given the status quo outcome and as concerns about a shift to relatively hawkish monetary policy under a Romney administration subsided. Never the less, the rally in US government bonds can continue, given the downside risk to growth and loose monetary policy for longer.

Corporate Credit

With the US electorate voting for the status quo, the markets will breathe a temporary sigh of relief because the election is over without any legal delays and Fed Chairman Bernanke remains in place, to guide monetary policy. Looking ahead, the markets expect the politicians on both sides of the aisle to move forward from the fiscal stand-off which has existed over the last two years, compromise, offer concessions and begin legislating on the fiscal cliff as a base case scenario. The tail risk, however, comes from the Tea Party Republicans who could hold the nation and markets to ransom with their conservative stance on fiscal policy and may tie negotiations on the fiscal cliff to the debt ceiling debate, which is also likely to be breached before the end of the year.

Since the mortgage crisis began in 2007, it may take an increase in risk premia across markets, especially US equities to convince politicians to act and which poses near-term risk to markets. The markets must not understate the importance of the fiscal cliff, as not acting on it will literally send US GDP growth over the edge, exacerbated by the impact of Hurricane Sandy. While Fitch warned that the US may be downgraded unless politicians avoid the fiscal cliff, and the debt ceiling in a timely manner, Moody’s stated that a downgrade was possible if the deficit was not addressed, but not if the US went over the fiscal cliff. While a rating downgrade may have little impact on US Treasury bond yields due to the continuation of Operation Twist and on-going QE, it could have a significant impact on risky assets; similar to July and August 2011 when the S&P 500 dropped from 1350 to 1100 within three weeks after S&P downgraded the US.

Furthermore, US banks could also suffer a similar rating downgrade, forcing them to post more collateral due to the sovereign downgrade and their own downgrade, a domino effect of sorts suffered last year by Spanish and Italian banks. This could be a vicious, deleveraging event to say the least and one which the credit market is far from pricing in at this point. The market is showing a bit of complacency here, as the differential between US bank and European bank spreads for EUR senior cash bonds is at its five year low and two past experiences show that a sudden upward spike in spreads cannot be ruled out. Similarly, US bank spreads are trading tighter than non-financial BBB spreads for the first time since the Lehman default and look relatively rich.

Meanwhile, the global economic slowdown and on-going political uncertainty in Europe have contributed to a decline in demand and corporate earnings so far this year. This will surely affect the credit quality of issuers globally as the current downward trend in ratings is expected to persist well into 2013. According to a recent S&P report, downgrades account for 82% of the total rating actions in Europe in Q3 and 76% of the total in the US. It is important to note, however, that the recent surge in the downgrade/upgrade ratio is due more to a strong decrease in the total number of upgrades, rather than an increase in the total number of downgrades. In addition, S&P emphasised that "although downgrades in the eurozone have been significant in the past several quarters, European credit quality is at risk of deteriorating further.

The European HY market was modestly wider this week, weakened by the drop in risk sentiment following President Obama’s re-election. While US equity markets appear to be increasingly concerned about the US fiscal cliff, European credit remains resilient as we exit Q3 earnings. Floored by a lack of progress in Europe, but capped by the threat of intervention by the ECB, markets are likely to struggle for direction until there is a more meaningful “break” in this stalemate.