Thursday, 20 September 2018

Tapering and the eurozone

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Divyang Shah draws a link between peripheral yields and tapering prospects.

Divyang Shah, Columnist

Divyang Shah
IFR Senior Strategist

The price action on eurozone peripheral sovereign bonds has been interesting since the Fed introduced the markets to potential tapering risks back in May.

While 10-year peripheral yields have all moved lower since Sept 18 only Spain and Greece have seen yields fall below their May pre-taper signal levels. While this suggests some potential catch-up for the laggards it also means that further downside on 10-year yields will be limited without specific positive news for the individual peripheral countries.

It was back in May that the Fed, via Bernanke’s testimony and FOMC minutes, raised the prospect of tapering risks. The impact of tapering risks was most evident in EM especially those with external financing needs and a large c/a deficit. The eurozone peripheral sovereign bond markets also saw a lurch higher on yields as investors worried about the prospect of lower global liquidity.

A chart of changes in 10-year yields since May 23 shows that only Spain and Greece have managed to claw back the weakness in their respective bond markets since May. For Italy, Ireland and Portugal their 10-year yields remain higher than in May with Portugal still having more in the way of catching up to do. Even for Italy and Ireland the extent of further downside on 10-year yields seems limited to another 15/20bp.

A glance at 10-year spreads highlights that on a relative basis (ie against bunds) optimism toward peripheral bonds has extended beyond the May levels for all peripherals except for Portugal.

As with the changes in 10-year yields, Greece stands out as being a star performer. While we view further downside on 10-year Italy and Spain as well as 10-year Ireland with caution there is room for further gains on Greek bonds.

We remain biased toward seeing the price on 10-year GGBs move to 85 cents during 2014, expecting that the official sector will eventually be forced to accept either OSI or debt rescheduling which should help existing PSI-ed bonds.

Also Spanish 10-year yields have moved to trading back above 10-year Italian yields and it is tempting to short 10-year Spain vs 10-year Italy, targeting the spread to move back to at least 30/35bp.

December taper risks low but not insignificant

Has the pendulum of market expectations swung too far towards expecting the Fed to keep the liquidity taps on and maintaining QE at US$85bn per month? Fed communication will look to stick to the prospect of a near term tapering that includes keeping alive the possibility of tapering in December. Unless the Fed is willing to signal it intends to taper in December, expect risk markets to remain exuberant.

Much of the confused Fed communication since May, and leading into the Sept FOMC meeting, was born out of a desire to prevent markets from thinking along the lines of “QE-ternity” and “QE-infinity”. The budget battle in Washington has led the market to think along those lines once again with some suggesting “Fed forever”. The hawks especially will want to discourage such thinking as we have the return of dip-buyers on equities sending the S&P500 to another fresh record high.

While tapering in October is unlikely, the December meeting could still be a risk, especially as markets have managed to navigate the budget battles with ease. However, the budget battle in Washington has simply been delayed until Jan/Feb and for the Fed to taper in December would mean a bet has been placed that ultimately a compromise will be reached. We have five Fed speakers in the form of Lacker, Tarullo, Evans, Dudley and Stein speaking today who will likely look to keep alive the prospects of a taper in December.

While the Fed might talk about a December taper the markets believe that the delayed budget fight in Washington until Feb 7 means that the earliest tapering meeting will be on March 18-19, with risks of tapering pushed out into Q2 2014. Risk markets have further to run when it comes to exuberance as Fed tapering is not in play and budget battles ultimately prove to be about more about political barking.

We shall be keeping an eye on Fed speakers, as while Dec taper risks are low they are not so insignificant that they can be completely ignored.

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