
Going solo: capital markets prepare for a world without QE

It has only been four years, but the European bond markets have become attached to the kindly hand of Mother ECB. Quantitative easing has been like an electric motor on the market’s bicycle — in 2019, it will have to go back to doing all the pedalling itself. Can the market do it without falling off, when the road ahead is so bumpy?
In June, European Central Bank (ECB) president Mario Draghi
announced plans to finish, by the last day of 2018, the quantitative easing
(QE) the ECB had started in March 2015 and will have seen the bank buy €2.65tr
of bonds.
For nearly four years, the demand from the central bank has
smoothed pricing in the euro bond market, kept the impact of potential
disruptions to a minimum and allowed the market to return to a state of
relative normality. But that comes with a tariff: dependency. Every market
participant has to be asking how will the market cope without stimulus. QE has
also introduced notable distortions, such as a difference in pricing between
investment grade corporate bonds from eurozone issuers eligible to be bought by
the ECB and the rest.
What bond specialists have to consider is how big the
withdrawal effect will be, over what period it will influence the market, and
what other factors will move pricing in 2019.
On the level?
The first question is whether Draghi is for real. In his
announcement in June, he retained the option to extend QE again.
The market is not expecting that option to be used. But the
ECB has form for being surprisingly trigger-happy. Its introduction of the
Corporate Sector Purchase Programme (CSPP) in 2016 surprised the corporate bond
market, which had seen little need for it as demand was good and spreads had been
tightening for years.
Some participants do foresee the possibility of the ECB
tweaking its approach. After weak growth in the third quarter, it might cut its
growth forecast, and then be more likely to use a further burst of QE or a new
Longer Term Refinancing Operation (LTRO)— cheap loans to banks. The threat of
an Italian debt crisis might also prompt the ECB to open the liquidity taps
again. However, the dominant view is that Draghi will stick to the path he has
taken.
“A lot of central bankers think of their legacy,” says Eric
Stein, co-director of global income at Eaton Vance, the Boston investment
manager. “In the US, Ben Bernanke had completed the effective [QE] programme
when he handed over to Janet Yellen. Yellen was responsible for the successful tapering
of that programme and restarting the raising of rates, before handing over to
Jerome Powell.
“Draghi will want to leave a legacy towards normalisation,”
he adds. “Problems in Italy could affect things and a weakness in general in
the car sector could affect things, but he will want to hand over with QE over
and rate rises on the horizon.”
Most agree that the ECB has telegraphed its intention to
quit QE fairly clearly and consistently, ever since October 2017, when Draghi
said the monthly purchases would be reduced from the already lowered level of
€60bn to €30bn. This means the market has had time to begin adjusting — indeed,
it may have done much of the adjusting already.
The gradual removal of the ECB’s big tickets in order books
for new corporate bonds might have been expected to stem the flow of business,
but Sarwat Faruqui, head of EMEA syndicate at MUFG Securities in London, says
that has not happened.
“Most names have had uninterrupted access to market, if they
were willing to price accordingly,” Faruqui says. “Yes, new issue concessions
are no longer minimal and levels of subscription have not been as high as they
were, but the takeaway is the surprising resilience, in the face of all the
roadblocks in the next couple of months.”
Issuers have made good use of the benign market conditions
the ECB has supported.
“Quite a lot of corporates have been taking the opportunity
to term out debt where they could, so it doesn’t feel like there are walls of
financing that need to be taken out come what may in 2019,” Faruqui says.
“Issuers have been pretty good at terming debt out and liability management
exercises. That, in most cases, has been a basic rates and credit cycle view,
and recognising that while, in the short term, it may be carry-negative [to
issue extra debt], it will bear fruit over the next year or two, in not being
forced to go to market in potentially more challenging circumstances.”
Corporate debt has already been repriced, and while it is
impossible to know if that is down to the dwindling of QE, it seems more than
likely that is part of the story.
The Markit iTraxx Europe Main Index, which holds 125 equally
weighted investment grade European credit default swaps (CDS), tightened from
more than 80bp in 2016 to 42bp by the end of 2017. However, it has already
returned to above 70bp, perhaps reflecting in part the ECB’s gradual
withdrawal.
Speculative grade bonds were not eligible for QE, but the
Markit iTraxx Crossover index, which includes the 75 most liquid CDS on those
names, moved from 350bp to 220bp between 2016 and 2017. It, too, has widened
again, touching 330bp in November 2018.
Bonds left behind at tighter levels are gradually catching
up.
“Spreads are wider. They have come a long way,” says
Faruqui. “This week my traders have said some bonds are 10bp-12bp wider on the
day with no particular news, but it is because they have outperformed the
broader market over the last week or two.”
Some bankers believe investors like the levels in the market
now, but may be holding back from buying for other reasons — for example, they
are hoarding cash in case they have to meet outflows from their funds.
“On the primary side quite a lot of potential negativity is
currently factored into new issue premia,” says Faruqui. “It is not surprising
there is a good deal of reticence from investors to put money to work
currently, after the year we have had. But come the beginning of the year,
people may take a fresh look at things 150bp wider from the tights and decide
that represents good value.”
David Riley, chief investment strategist at BlueBay Asset
Management, was already of that view in October.
“European credit fully discounts political risk, lower
growth and the end of QE, and there is room for spreads to tighten into year
end,” he wrote in the firm’s fourth quarter tactical asset allocation summary.
Mark Holman, managing partner at fixed income specialist
TwentyFour Asset Management, shares that appetite, although with caution.
“Credit spreads have moved too far generally,” he blogged in
late November. “We still think the most expensive part of the world is the US,
despite spreads having backed up the most. We see Europe, the UK and Asia as
more attractive.”
The value of experience
Faruqui believes the euro market’s experience of navigating
the 2008 crisis will stand it in better stead to trade through any issues the
end of QE may present.
“One or two investors talk about choppiness and spreads
gapping 10 years ago,” she says. “But nobody had really traded cycles in euros.
But now the euro market has matured. Yes, the price may not be exactly what an
issuer may want in the primary market, and liquidity may not be quite what an
investor might expect on some days, but there is an ability to navigate these
markets more comfortably than 10 years ago.”
That ability will almost certainly be called on, as the
number of unpredictable risks that could affect the market as 2019 dawns — from
a hard Brexit to a rift between Rome and Brussels — is probably more than it
has been since the end of the sovereign debt crisis.
The end of QE may turn out to be one of the easier obstacles
to clear, thanks to Draghi’s careful handling. Brexit may have much less effect
on Europe than on the UK. But growth in Europe is still a concern, and the
flames of such concern will be fanned by growing murmurs suggesting growth in
the US may have hit its peak and that the whispers of recession may
grow louder.
“Generally the corporate credit space is in good shape from
a fundamentals perspective,” says Stein. “But leverage is going up and growth
is not great.”
In Holman’s view, “Growth will certainly slow in 2019,
taking us nearer to the end of the cycle. But we could also see the resolution
of some of the geopolitical risks weighing on markets.”
Views on when the next recession will occur are far from
uniform, but there is a widespread recognition that it is not too far away and
2019 may show more evidence of its proximity.
Investors’ outlooks are starting to diversify more than at
any time since 2009, when economies started to rebuild after the crisis.
“I have felt over the last few weeks that there has been
much more debate between syndicates as to what is the right course of action,”
says Faruqui. “So it is harder to get to a consensus. That will make it
interesting next year and make meeting with borrowers and investors
interesting, as not everyone is saying the same things. I am looking
forward to exchanging a range of views.”
Syndicate bankers are able to trade opinions in a civilised
fashion. But money does the talking on trading desks, and it can be blunt.
“We saw the sizes traders were willing to bid for at screen
prices drop almost overnight after Draghi’s announcement about ending QE,” says
a bond trader at a Spanish bank in London. “The time it took us to turn bonds
over also grew materially.”
That effect is likely to go further next year.
“If you are going to remove a buyer of last resort, who can
buy in such size as the ECB has, it is going to impact secondary liquidity,
without doubt,” the trader says. “So we are not surprised, but it does mean
traders will need to use more of their skills and experience than they have in
recent years. And there are some traders out there whose experience in markets
without ECB buying is limited.”