The European Credit Strategist “QE”: careful what you wish for

BofA Merrill Lynch Global Research - Miercoles, 28 de Mayo

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Presenting: "The blip" After an almost constant tightening in the periphery year-to-date, the last fortnight has brought "The blip". Peripheral sovereign and credit spreads have been on a mini rollercoaster of late. The jump in sovereign yields, and then the big retracement, looks to have been driven by a combination of weak GDP data, heavy supply, declining yields and the outcome of the European Parliamentary elections. Or maybe it was simply a case of investors taking profits on one of the few consensus trades of 2014 that has so far worked out.  

Careful what you wish for 

Our core view remains that as long as the ECB is in action mode to revive a flagging European economy, money will continue to be forced into higher-yielding credit assets to generate better returns. Our economics team expects the ECB to act next week with rate cuts and possibly an announcement of credit support measures. But the last few weeks have shown the tension that the market may have to deal with on the road to more central bank stimulus and tighter spreads. Weak Eurozone inflation and growth data may be the trigger for ECB "QE" at some point, but both risk stoking concerns again over peripheral government debt sustainability.  

When bad news isn't necessarily good news 

Put another way, the market seems to be anticipating something (deflation) that is fundamentally bad for the periphery, in the hope that the outcome (more central bank liquidity) is a greater offset. We highlight our economists' debt sustainability work on the periphery to show the threat from Eurozone disinflation. In our view, this means a bumpy ride to tighter spreads in 2014 if the Eurozone inflation numbers continue to disappoint. 

Dominoes and peripheral relative value 

Sovereign government bond yields gapped tighter on Monday and Tuesday this week after the European Parliamentary election results. Peripheral credit spreads have reacted with less vigor both on the way out and the way in lately. Now that the dust seems to have settled, we see both good and bad value for peripheral credits.  

The screens say… 

We run screens looking at the changes in peripheral credit yields versus changes in peripheral government bond yields, across the curve. Overall, we find that 15-20yr peripheral high-grade credits look the least favourable at this point as bonds have underperformed much less their respective sovereign debt in this part of the maturity spectrum. Financials have cheapened up more than non-financials, especially at the front-end, in high-yield. By country, Spanish long-end financials look relatively less attractive now versus their sovereign debt in both high-grade and high-yield, while it's the reverse for Italian long-end financials.  

Tables 1 and 2 on page 7 show the important credits to think about now after the recent volatility in sovereign debt. 

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