The ECB delivered

GLOBAL GOVERNMENT BOND STRATEGY

Euro sovereign markets delivered strong performances in January and February with core markets outperforming given the combination of increasing global growth concerns and, further financial market stress.

In this context, expectations for the March ECB meeting were strong. Mario Draghi did not disappoint markets: he announced a broader package of measures beyond expectations (Table 1). Furthermore this decision was made with an “overwhelming majority”.

The ECB has cut policy rates across the board. While the deposit rate was lowered to -0.4% from -0.3%, the rates on the main refinancing operations and the marginal lending facility were lowered by 5 basis points to zero and to 0.25% respectively. Most surprising was the inclusion of non-bank corporate bonds in the composition of the QE programme. This is due to start towards the end of Q2 2015 but corporates have to be “established in the euro area” and the bonds eligible for repo operations to be bought. This will strengthen the pass-through of measures but the design is still work in progress.

Short duration stance on EMU core rates

In this context, the environment has been supportive for core sovereign rates in the euro area. But now, the yield curves, notably in the core area, are in expensive territory. Further, we consider that the disappointing macro news in the US are behind us now. Thus, the potential for interest rate increase is now much more elevated: we initiated a short directional bias on the EMU and US curves via an optional strategy.

Still positive on peripheral debts

Non-Core markets continue to be strongly supported by the monetary policy stance of the ECB and flow dynamics. Carry remains a supportive factor. Key for non-core countries will be Non-Core markets continue to be strongly supported by the monetary policy stance of the ECB and flow dynamics. Carry remains a supportive factor. Key for non-core countries will be the implementation of Greek program and political developments in Portugal, Spain and Ireland. Despite risk aversion at start of the year, pressure on non-core yields remained contained. We therefore keep our positive bias on non-core countries, principally via Italy as, compared to peers, political risk is much more limited. 

CURRENCY STRATEGY

Pacific currencies react differently to China and oil developments

Our indicators still put the JPY among our favourite currencies. (partly due to a cheap Purchase Power Parity valuation). Although investors are deeply short the currency, the trend is reversing, giving it an important rebound potential. Lastly, the BoJ remains confident that its easing programme will be sufficient to boost inflation but markets remain skeptical and pressure upwards the currency.

We continue to dislike the Kiwi. The softness of the business cycle in China will continue to pressure currencies of major business partners, New Zealand. Further, the fall in commodity prices is weakening the NZD. And, we think the Reserve Bank of New Zealand is ready to ease its policy in the near term to face downward growth and inflation pressures. Indeed, the country is entering into recession and the central bank has room to further cut its cash rates. According to our calculation of the Taylor rule for different countries, the central bank rate is too high.

More aggressive on EM Forex

At the current levels, we consider that many EM currencies are historically cheap after such downside (Chart 2). Policy divergence within developed markets is no longer supportive for USD after the riksy asset correction in January and February and the lower probabiliy of aggressive Fed hikes in 2016.

In particular, we are positive on currencies of oil exporters – the RUB, the MXN, the COP – on the view that oil stabilization is likely around current levels. More strategically, we favour the INR, which is benefiting from the improvement in investor sentiment on the back of good reform momentum and lower external sector imbalances. We also like many Eastern European currencies such as the HUF, the PLN and the RON, given the good mix of growth and inflation and expectations that European crossover investor demand will remain high.

However we remain cautious on TRY. Turkey remains one of the most vulnerable EM countries most dependent on short-term portfolio flows to fund its relative large current account deficit (4.5% of GDP). Turkey has also experienced significant increase in private sector debt (by around 20% of GDP) since 2010 – a vulnerability that is only partially compensated by the low level of household debt. On the positive side, the investment grade rating of Turkey has been supported by historically conservative fiscal policy and robust public balance sheet (33% public debt to GDP).