3 Things the European Investment-Grade Fixed Income Team Talked About Last Week

Tanguy Le Saout, Head of European Fixed Income, Pioneer Investments reviews the impacts in Europe regarding the Fixed-Income-market.

1. Japan – Negative Rates but Currency Strength
Economic textbooks tell us that lowering interest rates should lead to a weaker currency. That was probably what Bank of Japan Governor Haruhiko Kuroda expected when he introduced negative deposit rates in Japan in late January 2016. But in the intervening period, the Yen has actually strengthened – by over 9% against the U.S. Dollar for example, leaving most of the market scratching their heads as to the reason. As sometimes happens in the FX market, the reasons aren’t totally clear-cut, but we do know a few things. The introduction of “Abenomics” was meant to weaken the Yen, giving a boost to Japan’s export sector. Many overseas investors bought Japanese assets (especially equities), and hedged their Yen exposure. Now, however, with the Nikkei 225 having fallen and the Yen strengthened, investors appear to be cutting those positions and closing their Yen hedges, putting further upward pressure on the currency. Real yields (the difference between nominal yields and the inflation rate) have also moved in the Yen’s favour, mainly due to U.S. real yields falling – the spread between U.S. real yields and Japanese real yields has halved since early 2016. Plus many estimates of fair value for U.S. Dollar/Japanese Yen are still lower than current levels, with some models even suggesting that fair value is below 100. Finally, it’s worth mentioning that Japan’s February current account surplus was its highest in a year, and a current account surplus is usually good for a currency. There was increased talk last week of intervention by the Bank of Japan, but we think it unlikely in the near-term. Still, after such a large move, we think it wise to look for opportunities to short the Yen.

2. Global Central Banks – Losing their Mojo?
Had you met ECB President Mario Draghi the night before the last ECB meeting in early March and been told what was going to be announced the next day, the reaction would have probably been that the measures would have been supportive of “risky” assets. But the price action since has been quite startling. The table below shows the total returns in the intervening period. Shouldn’t further cuts in the deposit rate have had a negative effect on the Euro? And wouldn’t the generous terms of the new Targeted Long-Term Rate Operations have been good for the banking sector? The price action seems to suggest that global central banks are finding it increasingly difficult to impress markets, a point that was discussed in a recent roundtable discussion (Read here) between some of Pioneer Investments senior investment specialists. The view was that while orthodox and unorthodox monetary policies have contributed to the stabilisation of growth in recent times, they have also presented a number of drawbacks, and appear insufficient if not supported by expansionary fiscal policies and structural reforms. Central Banks are not the deus ex machina able to address the problems of high debt and weak systemic growth. Our investment specialists share the view that nothing comes for free. Markets are increasingly testing the effectiveness of global central banks, pushing them to over-deliver, but this strategy can become dangerous. The risk of disappointment is rising and could stir new waves of volatility. Without a turning point on the fiscal side, central banks could move from being part of the solution to becoming part of the problem.

3. Italian Banks – Progress in Sight?
Further news from the Italian banking sector came last week with the announcement that the Italian government is considering setting up a fund to underpin the rights offering of two banks, Banca Popolare di Vicenza and Veneto Banca, and another fund to buy bad debts from the banks. The fund will include Cassa Depositi e Prestiti (CDP), the bank controlled by the Italian Treasury, and various foundations, local charitable trusts, as well as private banks. Banca Popolare di Vicenza has started talking to investors as regards a €1.76bn rights issue, according to the Italian press. UniCredit agreed in September 2015 to underwrite up to €1.5bn of Banca Popolare’s rights issue, but is now fearful of being left holding the bulk of the rights issue. It’s a tricky situation for the EU and the Italian government – too much involvement by the latter will lead to claims by the former that the supposed package contravenes the rules regarding state aid to banks. Remember the new banking rules require that losses should be borne by the bank’s creditors, many of whom are retail investors. The news was enough to spark a significant rally in the Italian banking sector late last week, but whether it can be maintained is still to be seen. We continue to believe that an underweight position in Italian sovereign debt is prudent until we get further clarity on the banking proposals.