19 JUL

2017

Fixed Income , Topics

Spread trade long US vs. Short Eurozone, Partial Profit-Taking

Global Context

Activity cycle momentum continues to strengthen in the Eurozone and in Japan as the expansion stage remains well-anchored in both regions. The Eurozone in particular has seen confidence levels rise to their highest levels over the past 10 years. Though the US witnessed improved economic data in the second quarter, outlook remains dependent on the much-awaited fiscal stimulus that the government is yet to provide. In other developed regions, we note that nearly all of 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.

Europe seems to be taking centre stage on the inflation front as supportive datais omnipresent amongst the sub-indicators (wages, housing, consumers etc.) with a noticeable acceleration in the recent weeks. The inflation figures in the US appear to be stabilizing and could continue to do so without the material support of fiscal stimulus or oil prices. The global trend in inflation in G4 countries appears to be marking a peak following strong data accumulated since the beginning of the year.

These trends bring into question of the future actions of G10 central bankers, whose rhetoric indicates a move towards less monetary support (particularly the Fed and the ECB). 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 material improvement in the coming months, it is possible that the central banks are planning to tighten monetary support in order to build a cushion for 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, Partial Profit-Taking

Uncertainty of US policy, political risk in Europe, decelerating activity and a resolutely cautious Federal Reserve had led us earlier in the year to take a long position on the long end of the US curve. Furthermore, the woes of the Trump administration, which is unable to find the stability needed to deliver the much-awaited tax reforms and fiscal package, contributed to the unwinding of the reflation trade, with a decrease in the level of short positions on the mid to long end segment of the US curve. In Europe on the other hand, the further acceleration in activity and inflation cycle and the probable tapering of ECB QE (expected in September 2017) had incited us to hold a short position on the EUR curve. Stretched valuations and reduced political risk had also reinforced conviction on this strategy. Over the past few months, the long US vs. short Eurozone trade has delivered strong returns and we have taken partial profits on the long position in the US, which we still maintain amid a degree of uncertainty over inflationary and economic outlook in the US. We continue to hold a short position in core European rates, as inflation continues to edge higher and Draghi’s recent declarations indicated further tapering of ECB QE in September 2017.

Overweight peripherals

The non-core European bond markets continue to be supported by the ECB and flow dynamics are also positive. Furthermore, investor positioning remains close to the lows. We are therefore overweight Spain and Portugal, where valuations are still relatively attractive, but we remain wary of the specific political risk which justifies our cautious stance in Italy. Elsewhere, we have taken profits on our exposure to select Eastern European counties such as Lithuania, Slovakia and Poland.