... we almost hope those forecasts are proven wrong. They imply a widening gap between valuations and traditional fundamental relationships. They imply a dearth of yields and spreads that will almost invariably push more and more investors into positions they would ultimately rather not take. But if the old adage that markets move in the direction that causes the most pain to the largest number of people is anything to go by, then we suspect that this is what will happen. Depressingly, our instinct is that those new forecasts are more likely too conservative than too aggressive. Longer-term, sweet dreams really aren't made of this.
- Citigroup
It’s the ECB’s world -- € fixed income investors just live in it.
Or at least that’s what Mario Draghi and co. would like the market to believe. With the EU set to become the latest arena to host the increasingly fragile confidence game that now passes for monetary policy, investors are about to find out what happens to credit spreads when a central bank hell bent on monetizing annual net fixed income supply twice over collides head-on with both geopolitical turmoil and newly-elected, anti-austerity governments handcuffed by the will of their constituencies to campaign promises centered around billions (or trillions) in debt restructuring. To let the sell side tell it, the printing press is likely to triumph -- at least in the short-run.
As we’ve explained previously, the market’s propensity to front-run Q€ has so far been sufficient to avert a return to 2012-style carnage in the market for non-GGB periphery sovereign debt, even as Greece seems to be one or two vacuous ultimatums away from being, to use Credit Suisse’s words, "digitally bombed back to barter status." Eventually though, the whole "pay no attention to the man behind the curtain" gambit will be exposed and indeed we’ve already seen some cracks in the CB facade courtesy of the SNB’s FX widowmaker last month, but as Citi notes, the ECB’s final push to once and for all strip the € fixed income market of its rightful role as a price discovery mechanism hasn’t even begun.
From Citi:
...the distortions in € fixed income that ECB QE will create haven’t even started yet. Unless issuance picks up substantially, the lack of growth in € fixed income implies the ECB will be buying more than €600bn from existing investor holdings net over the coming 12 months. Fed purchases never exceeded net supply in $ fixed income over the QE3 period.
As a reminder, net issuance over the last four years has only averaged around €340 billion in the eurozone, meaning the ECB is set to monetize more than twice the net supply going forward:
[10]
What this means is that in relatively short order, credit spreads on € fixed income will signal exactly nothing and the perversion of capital markets in the EU will be complete as not even Grexit and/or the realization that cease fires in Ukraine seem to only apply to areas where no one was fighting in the first place will be sufficient to offset the ECB’s trillion-euro bazooka.
Conveniently, Q€ may well spill over into U.S. markets just in time to ensure a Fed rate hike doesn’t shake things up too much, because, as Goldman notes,
...European investors were more focused on [Q€] and thus had reflected more of it into Euro credit spreads. We expect lower fixed income yields in Europe will push the search for yield into USD fixed income [and] we think the significant spread compression between the US and Europe has increased the relative appeal of US spreads given what we think are better current and future US fundamentals. [Finally] our FX team thinks [Q€] will continue to drive the Euro lower against the US dollar, which should further encourage investors to seek yield in USD over EUR.
So, lower yields everywhere and always just because. This rather surreal state of affairs has even the beneficiaries of CB money printing lamenting the absurdity of the situation. From Citi again:
We now forecast the iBoxx € IG index to reach 60bp (from 70bp) and iTraxx Main to reach 45bp (from 50bp) by the end of the year – implying another 15% or so of tightening from current levels, keeping us at the very bullish end of current consensus.
Similarly, our target for Crossover is lowered to 245bp (from 295bp).
Truth be told, we almost hope those forecasts are proven wrong. They imply a widening gap between valuations and traditional fundamental relationships. They imply a dearth of yields and spreads that will almost invariably push more and more investors into positions they would ultimately rather not take. But if the old adage that markets move in the direction that causes the most pain to the largest number of people is anything to go by, then we suspect that this is what will happen. Depressingly, our instinct is that those new forecasts are more likely too conservative than too aggressive. Longer-term, sweet dreams really aren't made of this.
That is almost the same as if another famous Citigrouper had said, nearly a decade ago, that he hoped the music would finally stop playing.
