22 AUG

2017

Fixed Income , Topics

Spread trade long US vs. short Eurozone

Global Context

Activity-cycle momentum continues to strengthen in the Eurozone and in Japan, with the expansion stage still well-anchored in both regions. The Eurozone in particular has seen confidence levels higher than at any other time since 2007. Though the US witnessed improved economic data in the second quarter, outlook remains dependent on the much-awaited fiscal stimulus that the government has yet to provide. In other developed regions, we note that nearly all the other G10 countries are firmly in the expansion stages. On the debt cycle, we notice a slowdown in the US, while Europe and Japan now appear to be taking the lead.

The global trend in inflation in G10 countries appears to be marking a peak, as a result of the strong data accumulated at the beginning of the year. The deceleration is more pronounced in the US, where lower-than-expected energy prices, no wage-growth pressure and lower inflation expectations are preventing inflation from rising. In the Eurozone, the currency appreciation is raising the question of the expected inflation.

These trends bring into question the future actions of G10 central bankers, whose rhetoric (particularly that of the Fed and the ECB) indicates a move towards less monetary support. We note that inflation still remains broadly below central bank targets and the rebound in oil prices has failed to clear $50 per barrel. In the absence of any material improvement in the coming months, the central banks could tighten monetary support as a cushion against the next downturn. In such a scenario, we face an increased risk of CB policy errors (especially in the face of deteriorating debt dynamics and increased probabilities of an economic downturn), thereby making CB announcements and actions highly important elements to monitor in the coming months. 

 

GLOBAL RATES STRATEGY

Spread trade long US vs. Short Eurozone

In the US, expectations regarding economic expansion have been revised lower. There is a lack of progress in the reform process, the Trump campaign is still under investigation and economic indicators are sluggish. Recently, fears of an escalation with North Korea triggered a risk-off environment. Geopolitical tensions and weaker economic perspectives without any fiscal stimulus are responsible for our ongoing cautious investment approach.

In Europe, on the other hand, the further acceleration in the activity cycle and probable tapering of ECB QE (expected in autumn 2017) prompted us to hold a short position on the EUR curve. Stretched valuations and reduced political risk had also reinforced conviction on this strategy. We continue to hold a short position in core European rates, as Draghi’s recent declarations indicated that there would be a discussion about QE in the autumn.

Overweight peripherals

The non-core European bond markets are still supported by the ECB and flow dynamics are also positive. Investor positioning also remains close to its lows. We are therefore overweight Spain and Portugal, where valuations are still relatively attractive, but our remaining wary of the specific political risk justifies our cautious stance on Italy.