Following the intense focus of the ECB and US employment report last week, many market participants may well be looking for a continuation of the ‘race to the bottom’ in FX volatility, VIX, peripheral and corporate spreads.
Some may even be looking at the Football World Cup as an excuse not to get involved. Our view is that things are about to hot up (and not just for the England vs. Italy match in the midst of the Amazon).
"Concerned about complacency in Europe” – Christine Lagarde
Monday was a very significant day for global bond markets as the yield on Spanish 10 year government bonds declined below the equivalent duration US Treasuries.
We mentioned last week that the actions of the ECB and the de facto ‘rates on hold for 4 years’ implied by the TLTRO’s would likely lead to a short term flow of funds into European equities and bonds.
However, the implications for yield differentials are beginning to work their way into the respective curves / spreads. A clear example of this is the movement in EURUSD 2 year forward points which are now trading at their highs since Early 2012. The correlation to EURUSD suggests potential for further downside.
The real cost of borrowing in the US remains higher than in Spain as a function of higher baseline inflation and, indeed, the threat of deflation adds pressure for Spanish yields to fall further. Tuesday’s shockingly low inflation print from Holland at just 0.1% y/y, can only add fuel to the debate.
The core issue perhaps is whether the measures introduced by the ECB, will impact the fears of deflation and have the desired effect on aggregate demand. At the same time, the risk premium, as we see it, in European bonds is worryingly low.
Portuguese Finance Minister Maria Luis Albuquerque said "euro area nations must remember the lessons of the crisis and not count on favourable market conditions”, adding that they (financial markets) "will come back to collect if we do not do the right thing.”
Signs of faltering growth (particularly in the periphery) amid such stimulus and national indebtedness could see Eurozone bond yields sharply higher from here – and the euro sharply lower.
In broader market terms the targeted LTRO announcement from the ECB, the modest outperformance of the US macroeconomic data and the lack of geopolitical or macro negatives has led to a broad risk positive backdrop for financial markets. Monday’s targeted RRR cut from the PBOC (targeted specifically at agriculture and small companies) further underpins general risk sentiment (and likely contributed to the demand for Asian EM currencies, and yen, overnight).
Our approach in FX from here is also targeted. We are very much of the opinion that the ECB measures were a trigger point in FX markets and that the monetary and economic differentiation will bring about some significant movement in FX. Our favoured medium for the expression of that view remains selling euro vs. pound and dollar.
Neil Staines is global macro team head of trading and execution ECU
