The end of the year is usually favorable to risky assets and this year, however very unusual, is no exception. The outperformance of equity and credit markets appears fueled by the dollar’s fall, which is the distinctive feature of the reflation trade across financial markets.
In a three-speed world, Asia is well ahead in this cycle. The Chinese economy has been on a solid growth path since last spring. The yuan is gradually appreciating (6,53 vs. the US dollar) pulling most Asian currencies in its path. The move away from a dollar-dominated world to a yuan-based one is still remote, but the yuan may gain importance much faster than the 2030 deadline fo full convertibility would suggest. Across the pacific, the US has, as always, chosen economic growth over public health considerations, as the pandemic situation appears out of control. ISM surveys still point to a economic expansion but the deterioration of the sanitary backdrop will undoubtedly weigh on activity in months ahead. Employment is still growing at as solid pace with 344k new private-sector jobs added in November. Unemployment rate has dipped below 7% after a peak near 14% as the start of the pandemic. A fiscal plan worth $908b may be adopted by the US Congress. The House democrats’ proposal includes $160b funding for local governments, $180b for federal unemployment benefit schemes and $288b to maintain the Paycheck Protection Program along with bailout funds for the transport (airlines) industry hit hardest by the pandemic. The Europe is treading water as political shenanigans threatening the adoption of the multi-year EU budget, including the €750b recovery fund. Poland and Hungary have maintained their vetoes on the budget agreement just a few days as the EU summit looms later this week. In parallel, Brexit negotiations appear to be going nowhere although an 11th hour mini deal might still be possible. Against this backdrop, the ECB will have no choice this week but to ease policy further.
The heterogeneity in economic growth cycles is in stark contrast with the global reflation trade at paly across world financial markets. The upturn in US yields gathered pace last week as t-note yields came close to the 1% threshold. The market may be testing the Fed’s willingness to let yields drift higher. The yield curve steepened last week. Demand for mortgage credit is indeed so strong that significant paying interest is pulling rates higher. Yield targeting similar to the BoJ’s experiment of yield curve control could be a way to limit balance sheet expansion whilst maintain the curve steep. Operation twist is another possibility. The option to be chosen by Fed policymakers will also depend on the size of the fiscal stimulus to come and the Treasury’s strategy to refinance outstanding Treasury bills. Ten-year breakevens rose markedly last week by a whopping 12bp to 1.90% in the wake of higher oil prices as OPEC+ struck a deal to limit output growth to 500kbpd. In the euro area, the ECB meeting is this week’s market mover. The Bank may lower its growth projections and keep inflation forecasts low. The ECB will likely expand the PEPP by 300-500b over 6 to 12 months beyond the current deadline of June 2021 and may offer two additional TLTROs in the second half of 2021. The announced easing may further extend the rally in sovereign spreads. Indeed, Italian BTPs now trade within 120bp with Iberian debt yields on 10-year maturities hovering about 0%. The long peripheral bond consensus may however limit the upside from here.
We have observed a sharp richening in valuations in high yield space of late. Despite Moody’s forecasts of 6% default rate over 12 months sometime next spring, speculative-grade spreads have shrunk by a further 18bp last week to 353bp. The iTraxx Crossover is indeed trading within 240bp even as the current rating composition of the CDX market index would require a spread of 249pb at the minimum to compensate investors for historical average default risk. Investment grade corporate bonds in the euro area is also rallying, especially the financial sector, in spite of ongoing outflows from credit funds. New issue premiums have been quite reduced in the latest deals. In equity market space, the energy sector (+10.4% last week) helped by the OPEC+ deal and financials pulled indices higher last week. The rebound in banking stocks is traceable to rumors hinting at the possibility to pay dividends worth 15-25% of net income next year. The banking sector supervisor (the ECB) poured some cold water on such expectations late last week but hinting at another 6-month period of reduced payouts.
What to watch for next week
• ECB : further easing measures expected.
• Brexit, EU summit and US fiscal deal.