FLASH NOTE Flash Note Euro area: sovereign bond yields scenario update The dust settles after the Brexit vote Pictet Wealth Management - Asset Allocation & Macro Research 28 July 2016 The German 10-years Bund yield should remain low but rise slightly towards 0.08 by the end of October 2016. It is likely to stay under downward pressure due to political and economic uncertainty and because of the ECB s QE. 10-years peripheral bonds spreads, particularly Spanish, Italian and Portuguese, should remain volatile, with Italy underperforming Spain due to higher idiosyncratic risks (the constitutional referendum and banks NPL problem). AUTHOR Lauréline CHATELAIN lchatelain@pictet.com +41 58 323 4581 Pictet Group Route des Acacias 60 CH - 1211 Geneva 73 www.pictet.com After the Brexit referendum, the financial markets reaction and the change in our economic forecasts for the euro area have prompted us to change our euro area sovereign yields scenario, particularly our forecasts on the German 10-years Bund yield and on peripheral (Italy, Spain and Portugal) sovereign bonds spreads versus Germany. We lower our target on the German 10-years Bund yield to 0.08 from 0.8 for the end of October 2016 and anticipate an outperformance of the Spanish 10-years government bond yield versus the Italian one, with the Portuguese 10-years yield remaining higher. Financial and political situation in the periphery In order to better understand current market worries regarding the periphery, the banking sector and its impact on euro area sovereign yields, a quick overview of the non-performing loan (NPL) problem and the political landscape in the periphery is helpful. The NPL of Italian banks is adding to concerns over a sector that has underperformed the STOXX 600 by 20 year-to-date due to lower profitability. This is due mainly to lower-than-anticipated loan growth in Italy and Spain, as well as flatter sovereign yield curves, which reduce banks net interest income margins. Italy s weak recovery since the 2008 financial crisis led to a rise in NPLs, which, taking into account only loans considered as bad debts, stand at about EUR 200 bn, with an expected recovery rate of only 40. Under the Bank Recovery and Resolution Directive (BRRD), which determines how European banks can be recapitalised, a bail-in of about 8 of banks liabilities is required before public funding becomes available. In most cases, this would induce losses on equity and subordinated bonds holders. In the case of Italian banks, about 43 of the EUR 67 bn of banks subordinated debts is owned by Italian households. However, only 6 of households are exposed to non-equity investments subject to bail-in and they belong to the 10 wealthiest Italians (data above comes from the IMF and the Bank of Italy). Nevertheless, the bail-in issue is politically dangerous for the Italian prime minister, Matteo Renzi, as affected citizens could turn against him and reject electoral reforms at the referendum this autumn. Renzi has signalled he would resign if the referendum fails to pass, providing discontented voters with the possibility of triggering new elections. According to the latest
opinion polls, the anti-establishment Five Star Movement (M5S) is level with Renzi s Democratic Party (PD). For this reason, our best-case scenario is for an application of the bail-in rules with flexibility, enabling the Italian government to compensate some households for their losses, for example through tax rebates. However, the government will probably choose the easiest solution by dealing only with the most pressing recapitalizations, such as Monte dei Paschi di Sienna, and using private funds to avoid any bail-in. This would not provide a comprehensive solution for Italian banks NPLs. Credit default swap (CDS) spreads on European banks subordinated debts have widened in Italy this year, and this will probably continue until there is a systemic resolution of Italian bank NPLs (see chart 1). Chart 1: European banks subordinated debt average CDS spreads bp 500 French Banks sub CDS Italian Banks sub CDS Spanish Banks sub CDS British Banks sub CDS 450 400 350 300 250 200 150 100 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Source: Pictet WM - AA&MR, Bloomberg Since June 27, 2016, the day after the Spanish general elections, the Italian 10-years government bond yield has risen above the Spanish one, as political risk is now seen as higher in Italy and Portugal than in Spain (see chart 2). At the latest Spanish elections, the centre-right Popular Party (PP) performed better than expected at the detriment of the left-wing populist party Podemos, and is likely to form a minority government, if it cannot assemble a majority. In Portugal, the left-wing government elected last year has reversed several liberal reforms, for example by increasing the minimum wage. The complicated political environment in Italy, Spain and Portugal has led the bond market to focus again on credit risk, and on how political changes could impact fiscal and economic policies and therefore economic growth and inflation. 28 July 2016 FLASH NOTE - Euro area: sovereign bond yields PAGE 2
Chart 2: 10-years sovereign bonds spreads from the periphery vs. Germany bp 400 Spanish 10Y gov. bond spread Italian 10Y gov. bond spread Portuguese 10Y gov. bond spread ECB's QE announced Portugueses general elections ECB's QE expanded Spanish general elections 350 300 250 200 150 100 50 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Source: Pictet WM - AA&MR, Datastream Forecasts based on our risk factors In order to construct our forecast for euro sovereign bonds yields, we use our internal risk factor-based methodology, which evaluates the macroeconomic, market and investment environment for a particular asset. Macroeconomic risk factors. Two macroeconomic risk factors are worth highlighting: inflation and monetary policy. Inflation pushing yields higher: For almost two years, since oil prices fell in mid-2014, euro area inflation expectations have been declining well below the 2 inflation target of the European Central Bank (ECB). Our economists have revised down their average euro area economic growth forecast for 2016 from 1.8 to 1.5 and their inflation forecast from 0.3 to 0.1. They anticipate that headline y- o-y inflation will rebound from its current low level of 0.1 in June to about 0.8 at the end of 2016 and reach 1.7 by end 2018, helped by further policy loosening by the ECB. However, market expectations of inflation for the next 10-years, measured by the euro 5Y5Y forward inflation swap rate, are currently around 1.37. Market expectations of inflation therefore look excessively low, especially with the oil price holding up above USD 40/b (WTI). For this reason, we anticipate a small rebound in the German 10Y Bund inflation breakeven rate (currently at 0.83), as well as in the euro 5Y5Y forward inflation swap rate, and both should apply upward pressure to the 10-years Bund nominal yield (see chart 3). 28 July 2016 FLASH NOTE - Euro area: sovereign bond yields PAGE 3
Chart 3: German 10-years Bund yield & euro 5Y5Y forward inflation swap rate 0.7 German 10Y Bund yield Euro 5Y5Y inflation swap rate (rhs) 1.8 0.5 1.7 0.3 1.6 1.5 0.1-0.1 1.4 1.37-0.08 1.3-0.3 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 1.2 Source: Pictet WM - AA&MR, Bloomberg Monetary policy pushing yields lower: Monetary policy remains very loose in the main developed economies. And since the Brexit referendum, markets anticipate even more accommodative monetary policies. We expect the Fed to delay its next hike until December, the BoE to cut rates in August and the ECB in September to announce an extension of its quantitative easing (QE) for six months until September 2017. However, according to our calculations, the ECB could run into Bunds scarcity. It buys about EUR 16bn of them per month, with a remaining eligible universe of only EUR 100bn. The ECB should hit the issuer limit of 33 around January 2017. Hence it could also be forced to change the technicalities of its QE, for example by extending the issuer limit to 50 or by changing the capital key rule (see our Flash Note The ECB and the capital (key) question ). We expect an extension of the issuer limit, which would put even stronger buying pressure on long-term maturities, as only Bunds with a maturity longer than 7 years have yields above the deposit rate of -0.4, below which ECB rules forbid purchases. Our economists do not anticipate another deposit rate cut, due to the negative impact on banks profitability. For this reason, we think the rate cut priced into the EONIA yield curve by the market is excessive and EONIA yields at longer maturities should rise again, pushing the 10-years Bund yield upward. However, the increased buying pressure would likely cap its rise, unless the capital key rule is loosened, enabling the ECB to substitute Bunds purchases with peripheral sovereign bonds. Regarding peripheral sovereign bonds spreads, the ECB s QE maintains buying pressure and reassures markets that Draghi is able to do whatever it takes to avoid a drastic rise in spreads. Market risk factors. Two market risk factors are especially relevant at present, volatility and valuation. Higher volatility expected: Volatility was high on core sovereign bonds in 2015 (albeit still lower than during the euro area sovereign debt crisis of 2012). This is due to pronounced risk-off and risk-on 28 July 2016 FLASH NOTE - Euro area: sovereign bond yields PAGE 4
moves by investors, who regard German Bunds as a safe-haven asset to acquire in periods of market stress. With the Brexit referendum, 1- month volatility on German 10-years Bund spiked as its yield fell drastically (see chart 4). Volatility is likely to stay elevated until this autumn due to important central banks meetings and political events such as the Italian referendum and the US presidential elections. High volatility could prompt euro area sovereign yields to diverge strongly from our forecasts and fundamental values. Chart 4: German 10-years Bund yield & 1-month annualised volatility 1.1 German 10Y Bund yield German 10Y Bund annualised 1M volatility (rhs) 12 0.9 10 0.7 8 0.5 0.3 6 0.1 4-0.1 2-0.3 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 0 Source: Pictet WM - AA&MR, Datastream Demanding valuation: The Brexit shock pushed core sovereign yields to unprecedented levels (see chart 5). Core sovereign bonds now look even more expensive based on economic fundamentals. As a rule of thumb, on a long time frame sovereign yields tend to equal real economic growth plus headline inflation (y-o-y) on average. On this basis, the German 10-years Bund yield should lie close to 1.8, and definitely not be negative, but its safe-haven status and ECB QE are disturbing this rule. Chart 5: 10-years government bonds yields in the US, UK & Germany 4.0 US 10Y Treasury yield UK 10Y Gilts yield German 10Y Bund yield 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5 11 12 13 14 15 16 Source: Pictet WM - AA&MR, Datastream 28 July 2016 FLASH NOTE - Euro area: sovereign bond yields PAGE 5
Investment risk factors. The quality of euro area sovereign bonds is also a factor, as some bonds are considered as safe-haven assets and other (like Italy, Spain and Portugal) are perceived as riskier and subject to sell-offs during financial market turmoil. Divergence in quality between core and peripheral yields: The safe-haven status of the 10-years Bund and its resulting high correlation with the US 10-years Treasury lead to its yield falling in periods of financial market stress like the one experienced after the Brexit referendum. As economic and political uncertainty remains elevated and the fear of a systemic shock resurfaces in each pronounced turmoil, 10-years Bund yield should stay under pressure, and not rise significantly like in spring 2015 during the Bund tantrum. However, a likely rebound in the US 10-years Treasury yield towards 1.7 and a brightening of investors mood could still push its yield modestly higher. For 10-years peripheral sovereign bonds yields in Italy, Spain and Portugal, the political risk premium has resurfaced since last year. As risk rises, investors require a higher credit risk premium leading to wider spreads. As described above, the political environment is more uncertain in Italy than in Spain, where the clean-up of banks has already been effectuated through the creation of a bad bank (SAREB). Therefore, until a systemic resolution is found for Italian banks NPLs, and unless the referendum favours Renzi, higher credit risk premium should lead to wider Italian spreads relative to Spanish ones. Conclusion Notice: This document is not intended for persons who are citizens of, domiciled or resident in, or entities registered in a country or a jurisdiction in which its distribution, publication, provision or use would violate current laws and regulations. The information and data contained in this document are provided for information purposes only; the Pictet Group is not liable for them nor do they constitute an offer, an invitation to buy, sell or subscribe to securities or other financial instruments. Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial publication and may be changed without notice. The value and income of the securities or financial instruments mentioned in this document are based on rates from the customary sources of financial information and may fluctuate. The market value may vary on the basis of economic, financial or political changes, the remaining term, market conditions, the volatility and solvency of the issuer or the benchmark issuer. Moreover, exchange rates may have a positive or negative effect on the value, the price or the income of the securities or the related investments mentioned in this document. Past performance must not be considered an indicator or guarantee of future performance, and the addressees of this document are fully responsible for any investments they make. No express or implied warranty is given as to future performance. The content of this document is confidential and may only be read and/or used by its addressee. The Pictet Group is not liable for the use, transmission or exploitation of the content of this document. As such, the addressee of this document remains solely liable for any form of reproduction, copying, disclosure, modification and/or publication of the content of this document, and no liability whatsoever will be incurred by the Pictet Group. The addressee of this document agrees to comply with the applicable laws and regulations in the jurisdictions where they use the information reproduced in this document. This document is issued by the Pictet Group. This publication and its content may be cited provided that the source is indicated. All rights reserved. Copyright 2016. The German 10-years Bund yield should remain low, but rise slightly towards 0.08 by the end of October 2016. It should stay under downward pressure due to political and economic uncertainty and because of the ECB s QEs. Moreover, volatility will remain elevated and the yield could plunge again. 10-years peripheral bonds spreads, particularly Spanish, Italian and Portuguese ones, should remain volatile, with Italy underperforming Spain due to higher idiosyncratic risks. Portuguese spreads will remain relatively high as long as the left-wing government does not shift to more market-friendly economic policies. 28 July 2016 FLASH NOTE - Euro area: sovereign bond yields PAGE 6