Asian stock markets jumped after the ECB’s announcement and European shares opened higher, with some analysts saying the risk-on trade is back for now.
On Thursday, ECB President Mario Draghi announced more details about the bank’s plans to buy bonds, saying the purchases will be unlimited in size but confined to three-year maturities and will be sterilized to comply with the condition that the central bank must not finance member states’ debt.
“For Asia today it was really about broad-based risk-on with equity markets up between 2-4 percent,” Derek Halpenny, European head of global markets research at Bank of Tokyo-Mitsubishi UFJ, said.
The Shanghai Composite index closed 3.7 percent up, buoyed by the ECB but also by Chinese state media reports that the National Development and Reform Commission approved more infrastructure investment projects, estimated at $157 billion.
Other Asian stock markets also finished the day in the green while Europe stocks were also higher Friday morning.
The ECB’s signal should also benefit high-beta (high risk) currencies in emerging markets, according to Benoit Anne, head of emerging markets strategy at Societe Generale.
Anne recommended scaling back defensive positions in emerging market currencies unless these were “based on a bearish view of the Hungarian forint.” On Thursday, the government run by Prime Minister Victor Orban slammed reforms required by the International Monetary Fund (IMF), with Orban reportedly calling the measures a “list of horrors” on his Facebook page.
The long Turkish lira (TRY) versus South African rand (ZAR), which has been the ultimate defensive trade in EMEA, is “not doing so well now” said Anne, who added that he got stopped out of the long Brazilian real (BRL) –Mexican peso (MXN) trade in Latin America “owing to its overly defensive bias.”
WINNERS AND LOSERS
In the local bonds and interest rate swaps markets, “it is going to be fun to watch the differentiation at play there between the safe haven rates markets in emerging markets that will sell off, and those that will benefit from the risk-on mood,” according to Anne.
“To make it short, Israel rates up vs. Turkey rates down. In Latam, Brazil and Chile rates up vs. Mexico rates down - as long as the chances of QE3 [the third round of quantitative easing by the Federal Reserve] are not compromised,” he said.
Bank of America Merrill Lynch’s credit strategist Barnaby Martin also believes that the ECB announcement is good news for credit markets. “Yes, conditionality is still required,” Martin wrote in a market note. “But the bottom line is that the ECB seems committed to suppressing front-end yields in the fixed-income world. In our view, this adds to the need to buy higher-yielding corporate bonds.”
The ECB’s Long-Term Refinancing Operations (LTROs) at the end of last year and the beginning of this year showed that “competent policy intervention” can boost economic confidence and “lead to better perceptions around corporate fundamentals,” he pointed out.
“We expect some of the same this time around, and would expect high-beta credit to outperform low-beta credit,” Martin added.
Credit still looks cheap compared to equities according to the Bank of America Merrill Lynch analysts “and positioning is far from a crowded long.”
For emerging markets specifically, Societe Generale’s Anne believes investors should think about rotating out of local debt in favor of foreign exchange.
“Currencies have lagged the rates rally, and if the risk-on mood is confirmed with QE3, it is likely that emerging markets foreign exchange will now start flying,” he said. “There will be some nice catching up trades to look at.”
CAUTION AHEAD
But volatility is likely to remain high as investors’ initial enthusiasm for the ECB’s measures may fade once they read the small print.
Capital Economics’ senior European economist Jennifer McKeown warned that the details of the ECB’s measures show that it has not raised its policy support by as much as it might seem. “We doubt that markets’ positive response will be sustained,” McKeown wrote in a market note.
“A closer look at the details of the OMTs (Outright Monetary Transactions) suggests that they are not quite the bazooka that they might appear,” she wrote.
The reasons for this are the strong conditionality – with countries first having to go to the eurozone’s two rescue funds –, the ECB’s insistence that it will only resort to the OMTs to address “what it believes are unfounded fears of eurozone break-up” and its pledge to sterilize all of its purchases by taking deposits from commercial banks, according to McKeown.
Analysts point out that the next major hurdle that could threaten the risk-on trade is the decision of the German Constitutional Court next Wednesday on whether the European Stability Mechanism (ESM) breaches the constitutional prohibition against paying other states’ debt.