Calamatta Cuschieri Weekly Commentary – 07 December 2012

Eurozone

In its rate setting meeting on 06 December 2012, the ECB kept its refinancing rate unchanged at 0.75%, with no change to the balance of risks, i.e. downside for growth and inflation. As clearly pointed out, the ECB staff's growth forecasts were lowered once again and by more than expected. For 2012, the GDP growth range cut from -0.4% to -0.5%, and to -0.5 in 2013, well below the European Commission's latest forecast of 0.1% in 2013. The downward revisions to the 2013 growth and inflation forecasts were larger than expected and the first projections of 2014 forecasts shows inflation closer to the 1% level. If the 2014 inflation projection had been much lower than this, it could be viewed as setting the groundwork for a more substantial easing of policy, possibly through unsterilised asset purchases However, despite the low 2014 forecasts, Draghi certainly did not give the impression that the medium-term risks to inflation had altered materially. While rate cuts were in fact discussed, he continued to give the impression that the impact of the promised Outright Monetary Transactions on bond spreads and financial conditions had already been much greater than a small cut in the refinancing rate. As had been the case in the previous two press conferences, the message still seems to be that the central bank believes it has done all it can for now.

The overall tone of Draghi's comments was not as negative as the staff forecasts. Although the 2014 forecasts show inflation closer to 1% than to 2%, he insisted that the outlook for price stability had not changed substantially. He consistently reiterated that monetary policy is very accommodative. He also seemed to be fairly encouraged by the improvements in the German, French and Italian business confidence in November and emphasised that the impact of the promised OMT on bond spreads and financial conditions had was welcome by the markets as this spread compression was larger than the reduction in the base rate of the ECB.

Meanwhile, European Council president Herman Van Rompuy, in collaboration with the 3 other presidents of the ECB, Commission and Eurogroup released his final report “towards a genuine economic and monetary union” ahead of the discussion on the future of Europe due to take place at the European Summit on 13-14 December. Unlike the preliminary report, the final report is focused on the roadmap and the timeframe, whereas the draft report was more focused on the three areas where more integration was identified as necessary, namely financial policies, fiscal policies and macroeconomic policies.

The report puts the emphasis in the near-term on financial stability; enforcement of the new fiscal rules, establishment of the Single Supervisory Mechanism, harmonisation of national resolution and deposit guarantee schemes and, more importantly, the design of the operational framework for direct bank recapitalisation by the ESM, in compliance with the decision taken at the June European Summit, which is still controversial in some Northern European countries.

The report also focuses on the completion of the integrated financial framework with a common resolution and deposit guarantee schemes. The report remains deliberately vague to avoid being seeing as controversial in the first place, and is very open to the different options envisaged to secure a better integration of fiscal and economic policies, and refers to the Blueprint of the Commission as a toolbox for streamlining the debate. In particular, the question of the resources of the fiscal capacity is not settled as it could be based on national contributions, taxes and Eurobonds. This report is in fact expected to be at the forthcoming European Summit and it is still unclear whether it will be endorsed as such by Heads of States and governments.

US

The US Treasury market has been range trading since late summer, with the bands tightening in the wake of the early November election. Treasury yields from the 2-year through 10-year segment of the curve are now hovering at the lower end of these recent ranges. The balance of risks of the remaining major market events that occur between now and year-end leans towards Treasury yields breaking through the lower end of those ranges, and perhaps finding a new and lower trading range heading into 2013. Friday’s Nonfarm Payroll has been widely discounted by the market, with rates testing the range on the downside only if the unemployment rate rises.

The market is likely shift focus once again on the forth-coming FOMC meeting, and the Fed’s potential an-nouncement of an unsterilized Treasury buying pro-gram to follow-up the expiring Operation Twist. A sharp rally in US treasuries is on the cards if the Fed firmly commits to a new unsterilized, large-scale Treasury buying program, and then the fiscal cliff resolution produces a large drop in the 2013 deficit, limiting Treasury supply going forward. If the Fed chooses to shore up supply, as it is doing with new origination agency MBS, the 10-year Treasury could well heard towards the 1.00% level.

The near-term event for global markets is the FOMC meeting at which the Fed is expected to announce QE4 as Operation Twist ends. The Fed could maintain the headline purchase number of USD 45bn per month, but change the allocation such that the duration impact remains unchanged. Fed purchases would then have to move down the curve to offset the impact of the termination of sales, steepening the yield curve from the belly out to the 30y. The Fed could also reduce the headline purchase number to USD 40bn per month and keep the purchase mix the same, maintaining the duration impact of the Twist.

Forex

The EURUSD has pulled back sharply following Draghi’s reference to the rate cut discussion and negative rates. However, analysts do not think that policy action is imminent and suggest that the extent of the EURUSD pullback is more a function of the market environment than providing a policy signal. While the downward revision to German growth forecasts by the Bundesbank highlights a medium-to longer- term risk this should be limited in the near term by the prospect of the OMT.

Though President Draghi acknowledged that the central bank discussed the issue of negative interest rates on the deposit facility, this is not expected to happen any time soon. The ECB currently wants to fix the monetary transmission mechanism before resorting to conventional tools. Moreover, the discussion of negative rates was only briefly touched upon, suggesting that a majority of the board was not advocating such action.

In fact, leading analysts are view the recent EUR reaction to Draghi’s comments as a signal that the EURUSD rally is likely to become more volatile as year-end approaches, and holding above the 1.2905 level will now be important to maintain the EURUSD recovery trend, as the market reaction to the ECB on Thursday clearly explains the state of the market rather than points towards potential policy shifts.

Corporate Credit

The actions of global central banks created a unique opportunity to take risk in the first half of 2012. These policies are expected to remain heading into 2013, with credit markets remaining the beneficiary of a global reach for yield. However, most parts of the credit market are limited in terms of capital appreciation and credit has become more of an income asset class with a few notable high beta exceptions. Given limited opportunity for upside, modest global growth forecasts, macro concerns in the US, Europe, China, and the Middle East, and the potential for an increase in leverage from industrials, most parts of the credit market could struggle to return much more than their coupon.

2012 was a record year for credit. Supply reached new heights in several markets, such as US Investment Grade and High Yield. Despite this influx of supply, technicals remained extremely robust. Yields declined to new all-time lows in much of the market, driven by both tighter spreads and the effect of central bank actions on risk-free rates. Many of these thresholds were broken in the fall as systemic concerns abated following the announcement of Outright Monetary Transactions by the ECB in an effort to stem the European sovereign credit crisis. While performance was strong across the credit markets, the lowest credit quality parts underperformed, most notably on a beta-adjusted basis. This is not surprising, given the technical nature of the rally and on-going concerns about global growth.

The past two earnings seasons have provided a preview of how credit markets will trade in a low growth environment that is not overwhelmed by macro concerns. Correlation between regions and issuers has broken down, and companies that missed estimates were punished. While the developments in the European periphery, the fiscal cliff in the US, and slowing growth in China will all have an effect on markets, any swings are not expected to be as extreme as in the past few summers, thanks largely to the liquidity provided by global central banks. Investors will diversify by looking for the parts of the market that have lagged and taking a view on whether there are catalysts for change in 2013.

Bond Picks of the Week

? € 6.375% Commerzbank AG 22/03/2019 (BBB rated) @ 106.00 (Subordinated, Tier 2 Capital)

? € 6.00% Macquarie Bank Ltd 24/09/2020 (BBB rated) @ 107.50 Subordinated, Tier 2 Capital)

? € 8.50% Labco SAS 15/01/2018 (B+ rated) @ 104.00 (Senior Secured)