Mar 18, 2023
BlueBay, Algebris Say It’s Time to Bet on ECB’s Inflation Drive
Even after days of market turmoil, Carmignac Gestion SA, BlueBay Asset Management LLP and Algebris Investments say haven assets are no place to be.
The way they see it, the banking sector shock that drove German short-maturity bonds to their biggest weekly rally in thirty years is starting to look overblown and presents an opportunity to bet interest rates in the eurozone will climb.
As central banks including the US Federal Reserve and the Bank of England prepare to meet next week, some investors are gearing up for what Citigroup Inc. calls the coming “bearish reversal.”
They’re buying derivatives that pay out when yields on short and long debt converge, positioning for higher European Central Bank rates, and placing wagers on the euro and even riskier emerging-market currencies, like the Mexican peso.
The banking sector problem “isn’t as big, as broad or as extended as some people think,” said Algebris portfolio manager Gabriele Foa, who is long the euro and peso.
“The trade that’s opening up in markets — and that we are trying to participate in — is that risk should be strong and interest rates should be higher than what the market is pricing at the moment.”
That might seem bold after the market gyrations from Silicon Valley Bank’s collapse and as regulators rush to put together a deal to prop up Credit Suisse Group AG. There was speculation the ECB could avoid hiking rates altogether on Thursday to avoid tightening financial conditions even more and exacerbating the economic fallout.
Hawks Line Up
But the ECB’s 50-basis point increase and a pledge to take each meeting as it comes, suggests to Foa and others that policy makers will seize on chances to tighten when they can. Foa sees the ECB’s terminal rate at 3.75% to 4% compared with the 3.2% implied by money markets.
After Thursday’s decision, hawkish ECB policymakers lined up to stress their focus on inflation and downplay the risk of systemic risk in European banks. Governors from Estonia, Lithuania, and Slovakia suggested the economy still needs another phase of tightening after the global turmoil fades.
Core inflation remains “problematic,” said Mark Dowding, Chief Investment Officer at BlueBay Asset Management, who predicts the ECB’s deposit rate will peak around 3.75% in the summer.
“Obviously, any threat to European banks could imperil this trajectory,” he said. “However, we do not see many reasons for concern across the sector, away from what is happening at Credit Suisse.”
Lots of Psychology
To be sure, the last two weeks show how swiftly and violently market sentiment can turn. Investors say it will take time to shake off worries about financial stability.
Gauges of implied rates volatility hit the highest levels since late 2022, while German two-year bonds traded in the widest peak-to-trough range on record Wednesday, according to data compiled by Bloomberg going back to September 1990.
ECB chief Christine Lagarde’s pledge to be data-dependent at future meetings points to the potential for rapid reappraisals of the rate path — and more volatility.
There’s “a lot of psychology involved so you cannot exclude that things will get worse,” said Jan von Gerich, chief analyst at Nordea Bank Abp.
Nonetheless, “market pricing looks a bit on the low side and there is room for it to increase,” he said.
The ECB’s focus on inflation hints at how the Fed, BOE, the Swiss National Bank and the Norges Bank may react when they meet next week.
Central banks are “set to stay ‘tough on rates’ in order to protect their inflation credentials,” Commerzbank AG strategists wrote in a note to clients. “Current valuations at the front-end look unsustainable.”
There are some tentative signs that concern about broader financial sector risks may be receding. Gauges of funding stress — such as cross-currency basis and the spread between forward measures of interbank borrowing costs and comparable overnight rates — have eased from this week’s extremes.
“Our perception is that markets have removed too much of what was priced in for the ECB’s terminal rate, so a return of some of that is expected,” said Michael Michaelides, Group-of-10 fixed-income strategist at Carmignac, who sees at least another two 25-basis-point hikes from the ECB.
“If in two weeks we’re not talking about banking stress, I think we will be returning to the old playbook.”
- Investors will also look for clues on the future path of rates from the slate of scheduled European Central Bank speakers, including Lagarde who addresses the central bank’s ‘Watchers’ conference. BOE’s Catherine Mann speaks after the UK policy outcome
- Euro-area, German and UK PMI figures for March will offer an early glimpse of economic sentiment as will German ZEW numbers. UK inflation data ahead of the monetary policy decision is forecast to slow in February
- Bond sales from Germany, the European Union, Finland and Belgium are set to total almost €16 billion ($17 billion). The UK will sell two gilts, seeking to raise £5.5b.
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