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.”