1. European Inflation – a Black Swan?
Some things can truly be described as rare events – the wrong film being announced as an Oscar winner and the discovery of 7 new planets being two recent examples. Last week we were able to add to that collection, with Euro-area inflation hitting the ECB’s target of 2%. Not since January 2013 has headline inflation in Europe been at 2%, but last week’s print will provide an awkward backdrop to this week’s ECB meeting in Frankfurt. All the more so since German inflation rose to 2.2%, its highest level since mid-2012. By now most people are aware that last week’s number is likely to be the peak, certainly for 2017 and possibly for longer. So where does that leave the ECB and inflation-linked bonds? Whilst the 2% print is likely to attract plenty of media attention (certainly in Germany), we believe the ECB Governing Council will look through the headline number and note that core inflation (which was unchanged at 0.9%) has yet to show any signs of accelerating. Remember as well that ECB President Mario Draghi set out four conditions the ECB needed to see to be satisfied that inflation was meeting the ECB’s target – one of those conditions was that inflation had to be “durable”, and not just one month’s number. But we are already seeing some speculation in markets that the ECB could come under pressure this week to change their language by signalling that the deposit rate has now bottomed. That could be a way for Draghi to placate the hawks on the Governing Council, who may argue that current monetary policy settings are too accommodative. In terms of inflation-linked bonds, we believe that these bonds should incorporate a premium for the possibility of upside inflation surprises. Current valuations are based on the present inflation rate, but incorporate no premium. We continue to believe that inflation-linked bonds offer reasonable value at current levels.
2. French Elections – Quelle Surprise!
In true Gallic fashion, the French Presidential election campaign delivered some interesting twists and turns last week, keeping markets on their toes. The centre-right candidate, Francois Fillon, saw his campaign run into serious difficulties as he announced that he was under formal investigation into allegations of embezzlement of public funds when he was a Member of Parliament and employed his wife and his children. Previously, Mr Fillon had said that any formal investigation would lead to his withdrawal from the Presidential race. He has, however, back-tracked on that promise last week, saying he would continue his campaign and defer to the judgment of the French people. This decision did not sit well with senior members of his own party, who called for him to step down whilst others resigned from his campaign. The official deadline for registration of candidates is March 17th, so next week could bring some clarity. A former French Prime Minister, Alain Juppe, has been widely touted as an alternative to Fillon. But this morning, Mr Juppe ruled himself out of the race. The reality is that it is Fillon’s decision as to whether he continues or not. The polls for the first round are extremely close, but one thing continues to be consistent – all polls indicate that Le Pen will really struggle to win the head-to-head run off on April 7th. We feel that European bond markets are looking in the rear-view mirror when it comes to recent trading in French sovereign bonds. Having being caught out by the surprise results in the UK Brexit and U.S. Presidential votes, markets are taking no chances this time around when factoring in what might happen in the French presidential elections. Thus, we believe, markets are too pessimistic on the eventual outcome. The bookmakers got it wrong in the Brexit and U.S. votes, so why should we trust them this time? For a start, the gap between Marine Le Pen and either Fillon or Macron is substantial, way higher than seen in either the UK or U.S. votes. Secondly, Le Pen’s National Front Party are good at mobilising support for elections, but they find it difficult to get cross-party support, which is why she is unlikely to win in the second round in early April. Finally, the markets appear concerned about Le Pen’s promise of a referendum on EU membership. That means changing the French constitution, and that proposal needs to be approved by a majority of both upper and lower house members. Le Pen has little chance of achieving this. That’s why we think the widening of French government bond spreads is probably overdone in the medium-term. However, in the short-term, markets might react negatively to Le Pen winning the first-round vote, and spreads could widen even further. But we might be interested in buying French government bonds at wider spreads, so we be watching carefully that period after the first vote for potential opportunities.
3. German 2-year yields – what’s happening?
In the midst of last week’s excitement involving U.S. Federal Reserve speakers, French elections and Euro-area inflation, bond yields sold off significantly. But one area of the yield curve stood out for its performance, and that was the 2-year area of the German sovereign bond market. At one stage, German 2-year yields rallied and fell to -0.92%. Various reasons were put forward as to why this was happening – redenomination risk in the event of a French decision to leave the Euro, scarcity issues related to the ECB’s bond purchase programme and new rules concerning an imminent change in European collateral rules surrounding securities repurchase agreements. The truth is probably that some combination of all three reasons were to blame. As we mentioned above, French electoral concerns have impacted on the spread between German government bonds and French government bonds. Le Pen’s pledge (if she is elected) to hold a referendum on France’s membership of the Euro has brought the whole question of redenomination of French sovereign debt to investors’ attention, and some investors have sought the safety of short-dated German bonds to ride out the French Presidential election. There’s also a supply/demand imbalance in short-dated German debt. The ECB continues to be large buyers of this area of the German yield curve via their bond-buying programme, but the German national debt office will be issuing €1bn less 2-year bonds in 2017 compared to 2016. This scarcity issue is also being exacerbated by changes in collateral rules for repo agreements, whereby AAA-rated securities are in strong demand to back those repo agreements. Perhaps the best indicator is the chart below, showing that 2-year German swaps have not kept pace with the rally in their sovereign counterparts. This would suggest that the rally is being driven more by technical factors rather than political concerns. We expect the gap between 2-year German government yields and swap yields to narrow in the coming months.