Monday, July 9, 2012

Down they go

Just a quick update following the ECB's rate cut last week:
1. I expect the outperformance of the semi-core markets (AT, FI, NL, FR, BE) within the Eurozone government bond realm to continue. I expect bonds of these sovereigns issuers to converge across the curve at tighter spread levels to Bunds than is currently the case. With Bund yields trading around 0% at the short end and close to record lows at the long end, the incentive for investors to move elsewhere is increasing. I think that the semi-core markets offer an attractive risk-reward. My favourite remains Belgium (while debt-GDP ratio is high, there is no chronic or acute growth problem and the deficit is ok-ish so there is no need for large austerity measures) which should outperform markedly within this group.
2. The money-market curve should continue to flatten and I look for new highs in the Euribor futures, especially in longer-dated ones. The ECB has not yet reached its final stage in monetary easing. Whatever it will do (lower the repo rate, add more liquidity via another LTRO, lengthen the time-period of the LTRO), it should in conjunction with the announced steps towards a banking union help to lower systemic risks in the Eurozone banking sector and pressure money-market rates even lower.
3. The Euro is in a structural downward trend which will last several years. Eurozone assets remain too expensive vs. the rest of world amid the substantial risks. While in the first step, capital flight involved moving capital out of the periphery into the core countries, I see substantial risks that capital flight will  increasingly take place out of the periphery and the core in favour of other currencies. The 0% depo-rate by the ECB only reinforces this longer-term trend. As this happens, it helps the peripheral countries to regain competitiveness vs. the rest of the world (though not necessarily vs. Germany) and the Eurozone will move into a current account surplus position.
This fundamental outlook has been confirmed by the technical picture. As the chart below shows, EURUSD has finally broken through the decade long upward trend on the weekly charts.

Weekly EURUSD: long-term trend has been broken

Source: Bloomberg