A message from the ECB

admin | March 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The latest move by the European Central Bank to ease monetary conditions after ending its effort at QE just last December highlights the difficult line that central banks have to walk in meeting their mandates these days. Inflation remains stubbornly low in Europe and growth in China and the US has been slowing. The Fed decision to wait before making its next move looks increasingly good, but uncertain global conditions could make the wait long. The likely narrow range in rates as all of this plays out continues to make carry more important.

The ECB on February 7 announced a third round of targeted longer-term refinancing operations, or TLTRO. These programs offer loans to banks along with incentives to increase lending to businesses and consumers in the euro zone. The first TLTRO launched in 2014, the second in March 2016. The latest round provides loans through 2021, but some analysts have suggested the ECB will continue rolling over this program as long as necessary.

Perhaps more importantly, the ECB extended guidance to the end of this year and lowered its 2021 inflation forecast by 20 bp to 1.6%, signaling that it may keep rates lower for longer than the market had expected. It also cited downside risks to its outlook, although most of those were external.

The ECB’s move could push the Fed’s patient waiting out further than the Fed might have expected when it reset policy early this year. The ECB found itself offside relatively quickly after ending QE in December, and presumably the Fed will revisit its own view of US and global growth and inflation after the ECB move. As my colleague, Stephen Stanley, as pointed out recently, most of the crosscurrents clouding the best path for the Fed should be resolved by June, but global outlook always has had potential to linger. The ECB move suggests that is definitely the case.

On one hand, a flat yield curve and stability in rates should keep giving fixed income portfolio incentive to find carry in spread products. Some of the tightening in spread products — in MBS, investment grade and high yield corporate debt, leveraged loans and other markets – reflects the better bid for carry. The bid looks likely to only keep getting stronger.

On the other hand, the uncertainty on the part of the ECB and the Fed revolves around whether growth will slow to a sustainable plateau, at least in the US, or decline into recession. US recession still looks unlikely, but the debate poses risk for credit markets. Although US corporations have started responding to concerns about leverage by retiring debt and selling non-core holdings, many of them still remain vulnerable to the lower revenues that come with slower growth. Investors should play corporate credit defensively and balance that will the risk and carry available from exposure to household balance sheets, which are much stronger.

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The view in rates

The 2.63% rate on 10-year Treasury notes looks rich to fundamental fair value but understandable in light of the ECB move and a week report on February payrolls; the 2.47% rate on 2-year notes looks fair against a Fed unlikely to move this year and, possibly, next year. Breakeven 10-year inflation continues to hover below the Fed’s 2.0% target, sitting at 1.90% in recent days. The slope of the yield curve between 2- and 10-year notes remains, at around 16 bp, slightly more shallow than recent months. More importantly, implied volatility remains within shouting distance of historic lows. Carry and other risks this year, much more than interest rate risk, should dominate fixed income portfolio returns.

The view in spreads

With the yield curve flat, rates steady, and those conditions likely to persist, carry matters more to fixed income returns. MBS could widen a little this year if new bank liquidity rules reduce bank demand for MBS. Healthy MBS net supply could also weigh on spreads. But low volatility argues for MBS. MBS should still outperform corporate credit. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt.

The view in credit fundamentals

Household balance sheets look strong, and corporate balance sheets look vulnerable. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. Of course, this all can continue for a long time if growth persists. The Fed has signaled that it stands ready to buffer any material softening in growth. Still, corporations may need to trim equity buybacks and reduce debt.