Macro & FICC Research Published: 2021 10 08 05 57
SEB FI & FX Strategy
Energy crunch stress testing markets
Summary:
In market focus. Energy crunch; Inflation; China woes; Tapering; US debt ceiling.
Global macro and risk appetite. The general uncertainty has continued to increase on the back of weaker macro data, growth anxiety, surging global energy prices, high inflation, China woes and the Fed’s tapering plans. The US debt ceiling deadlock may become a concern in November unless resolved. A continued rise in nominal bond yields would risk spilling over to real yields, likely weighing on risky assets. Expect a volatile Q4.
China: Broadening downside risks to growth. The official manufacturing PMI declined into contraction territory in September, suggesting that industrial production likely declined on a sequential basis. China’s energy crunch is capping production with a combination of factors, including weather-related shortfalls and environmental targets, exacerbating the impact of the tight coal supply.
USD rates: Hawkish Fed and energy prices lifting long rates. Long rates have increased sharply over the past two weeks following the hawkish tapering outlook by the Fed on 22 September, driven by rising inflation expectations on the back of skyrocketing energy prices. US CPI swaps have now reached levels where a further increase would imply markets starting to discount risks of inflation overshooting over the longer term.
The larger-than-expected surge in energy prices has shifted risks to our end 2021 target of 1.50% for the 10y Treasury yield to the upside but growth related uncertainty and shaky risk appetite act as mitigating factors.
US: Debt ceiling – kicking the can down the road. Last week, Treasury Secretary Yellen said that the Treasury will run out of cash after 18 October, which begun lifting yields on Treasury instruments maturing in the second half of October. This week, the US Senate agreed on a temporary solution, which will raise the debt ceiling enough to last until early December. The agreement will remove one possible obstacle for the Fed’s tapering decision on 3 November, assuming a decent labour market report later today. The US could, however, find itself in a new fiscal cliff situation in early December, when the debt ceiling issue coincides with the need to agree on another temporary funding for the Government.
US: Wider USD LOIS, lower EURUSD XCCY basis after the debt ceiling is resolved. Once the debt ceiling issue is resolved, Treasury will kick off a massive T-bill issuance, which will increase the cash at Treasury’s TGA account and draw down reserve balances in the banking system. This is likely to put some upside pressure on USD Libor vs. OIS spreads and mitigate the downside pressure in short USD money market rates in general. Seasonal factors, upcoming Fed tapering and a likely decline in the Fed vs. ECB’s balance sheet in 2022 also suggest lower EURUSD XCCY basis, which are currently trading near multi-year highs.
Euro area: Inflation heading to 4%, high energy prices a downside risk to growth. Supply shortages of natural gas, sharply higher prices for coal and carbon emission rights and rising demand have created a perfect storm in energy markets. We estimate that the contribution from energy prices will push inflation towards 4% and possibly beyond at the end of this year. High energy prices also constitute a downside risk for the business sector, as it is likely to have very little protection from rising market prices. The ECB is likely to remain tolerant, especially if core inflation remains subdued the way we expect.
ECB: Avoiding sending policy signals ahead of December meeting. Yesterday’s account of the September meeting did not offer any new clues on policy prospects. At its next meeting on 16 December, the Governing Council has to decide on the policy for H1 2022. According to ECB sources cited by Bloomberg, the bank is
considering a new bond buying programme. Such a programme would be in line with our expectations that the ECB will either boost purchases under the APP or introduce a temporary post-pandemic programme to facilitate a smooth transition to the post-PEPP era (more here).
EUR money market: Front end on the move on excessive liquidity worries. Euribor vs. €STR basis increased in September mainly due to market expectations of declining excess liquidity in 2022. With the ECB’s asset purchases expected to add at least EUR 750bn of liquidity by end 2022 and the euro area governments potentially drawing down their elevated cash holdings at the central banks, we think Euribor vs.
€STR spreads are unlikely to widen as much as priced by forwards, even in case of substantial redemptions of TLTROs next year.
EUR/USD: Near-term upside risk especially if oil and gas prices correct lower. EUR/USD has continued lower in line with our trade idea in Currency Strategy, 16 September, although it has admittedly moved a bit faster than what we envisioned. Currently, we see a near-term upside risk as the move lower has been faster than supported by its fair value over the past few days. We also see a risk of a larger correction higher as petrol prices could continue to correct lower. For a chart package on EUR/USD with technical levels, fair value and drivers as well as positioning, please see here.
Scandies: Scope for lower EUR/SEK while risk/reward argues for position for higher EUR/NOK. Near-term we see scope for EUR/SEK to approach the 10 level, where, among other things, the surge in IPOs in Sweden is likely to draw foreign capital into the local equity market. Risks to such a scenario are lower risk appetite as well as the robust seasonal pattern for higher EUR/SEK in October. With support from a wider rate spread vs.
EUR and rising oil prices, EUR/NOK fell below 10.00 early this week. However, to remain below this psychologically important level, we think the NOK will need further support from rates and/or oil prices, which we are questioning at the moment. Combined with poor seasonality for the NOK in October, we think risk/reward points to a higher EUR/NOK. October seasonality also supports the combination of these two views, i.e. lower NOK/SEK. Read more in What’s Up Sweden and Norway.
Forecasts: Minor upward revision to long EUR rates forecasts. We have made a minor upward revision to our forecast for long EUR rates, now targeting the 10y Bund yield at 0.25% at end 2021 ( 0.35%
previously) with upside risks. Find comprehensive forecasts here.
Summary of views and trade recommendations. See tables at the end of the report for a brief summary of our macro, FI and FX views for the US, euro area, Sweden and Norway, and a list of trades.
China: Broadening downside risks to growth
Better-than-expected growth in Q1 led to some upgrades in 2021 GDP growth forecasts. The recovery allowed the authorities to focus once again on structural issues, such as managing financial risks and attaining environmental targets. However, structural targets have brought about some growing pains. Tighter regulation has not only led to downside pressure on Chinese assets but also led to conflicting priorities. Thus, we lower our GDP growth forecasts to 8.2% in 2021 and 5.2% in 2022 (previously at 8.6% and 5.6%
respectively).
The official manufacturing PMI declined into contraction territory in September, suggesting that industrial production likely declined on a sequential basis. In the last month, more than half of China’s provinces reported their worst energy supply disruptions in more than 10 years. A combination of factors, including weather-related shortfalls and environmental targets, has exacerbated the impact of the tight coal supply.
Thermal coal price has more than doubled since April 2021. As a result, manufacturing firms were instructed to halt production at varying degrees. Some firms were disconnected from the power grid for a few hours.
However, energy-intensive sectors were instructed by local authorities to stop production for several days.
Some households in a few provinces were also subject to a form of power rationing. Although the government has already allowed domestic production of coal to rise along with a near-term increase in energy imports, it will take time before the situation normalises, in our view. Even so, we expect the authorities to prioritise stabilising residential power supply in the coming winter months, even if it comes at the expense of commercial and industrial users.
US rates: Hawkish Fed and energy prices lifting long rates
As discussed in previous editions of SEB FI & FX Strategy, we think the growth anxiety has been the primary fundamental reason that has dampened long-term policy rate expectations since early summer, resulting in the terminal rate (illustrated by USD OIS 10y1m forward rate in the chart below) declining from near 2.50%
in March to a bottom of 1.60% on 22 September. Over the past two weeks, long-term policy rate expectations have increased, despite not much indicating an improvement in the underlying economic outlook. If anything, the sharp rise in energy prices combined with China-related uncertainties suggests that the growth outlook has become more uncertain. The rise in market expectations concerning future short rates has been driven by more a hawkish-than-expected tapering message at the September FOMC meeting and surging energy prices feeding into inflation expectations.
US short rate expectations: USD OIS 1m, 3y and 10y forwards
At the FOMC meeting on 22 September, Chair Powell’s comment that tapering could be concluded “around the middle of next year” suggested faster tapering than markets had expected. Fed funds futures and OIS forwards are now discounting nearly 30bps higher short rates by the end of next year and approximately 110bps in total by end 2023. Market pricing is almost in line with Fed DOTS through to 2023, but still around 25bps below the DOTS in 2024.
USD OIS 1m forwards and Fed DOTS (median)
The sharp rise in long rates in the days after the FOMC meeting was accompanied by a rise in both real yields and inflation expectations, which pushed the 10y Treasury yield close to 1.60%, which is above our end- 2021 target of 1.50%. We have argued for quite some time that the rise in long Treasury yields will be most likely driven by real yields, with only a minor increase in market-based inflation expectations. The larger- than-expected surge in energy prices is now testing this assumption.
Inflation expectations approaching levels consistent with overshooting inflation. So far, markets have subscribed to central banks’ view of transitory inflation, but US CPI swaps have now increased to levels where a further increase would signal markets starting to discount risks of inflation overshooting target, not only in the short term, but also over the longer term. The recent rise in market-based inflation expectations
has taken US 5y5y and 10y CPI swaps nearly back to YTD highs of early-May. The increase in CPI swaps has been driven by skyrocketing energy prices; the upside pressure on energy prices suggests that inflation expectations may breach the previous YTD highs. Whether the rise in inflation expectations will result in higher nominal yields depends on real yields.
We have argued that real yields will trend higher once the growth anxiety begins fading, which we think may take some time. A substantial increase in real yields in the current environment could jeopardise risk appetite, which in turn would likely trigger safe-haven buying in Treasuries, essentially limiting the upside in yields. However, if the rise in nominal yields is driven foremost by rising inflation expectations, the threat to risk appetite from higher rates should be more limited, at least as long as markets are not pricing a substantial long-term overshooting of inflation. We think that current levels of long-term inflation expectations are fundamentally reasonable. While it can be argued that markets should price some risk of inflation remaining above target for longer, our main scenario is that long-term inflation expectations are unlikely to rise substantially above their current levels. In that case, a continued rise in nominal yields would start to increasingly feed into real yields.
At the press conference on 22 September, Chair Powell said that inflation expectations anchored around the target would be the “ultimate test” for rate hikes, indicating the Fed’s preparedness to act. The prospect of more aggressive Fed policy in the face of mounting longer-term inflation pressures should also act as a drag for inflation expectations.
US: CPI swaps
To conclude, we revised our end 2021 target for the 10y Treasury yield, from 2.00% to 1.50%, in the summer when the growth anxiety gained ground. For now, we stick to our 1.50% target, but acknowledge that risks have shifted to the upside.
US: Debt ceiling – kicking the can down the road
The US Treasury has conserved cash using emergency measures since 1 August, when the debt ceiling was reinstalled. Last week, Treasury Secretary Yellen said that the Treasury will not have enough cash to meet all commitments after 18 October. This is in line with the estimate by the Bipartisan Policy Center (BPC), which said that the Treasury will most likely have insufficient cash to meet all its financial obligations sometime between October 15 and November 4 (the so-called “X date”). According to BPC, the Treasury will be unable to meet approximately 40% of all payments due in several weeks following the X date. This would likely mean prioritisation and delayed payments, but substantial uncertainty exists about operationalising them.
This week, the US Senate agreed on a temporary solution, which will raise the debt ceiling enough to last until early December. We draw the following conclusions:
1. The agreement will remove one possible obstacle for the Fed’s tapering decision on 3 November. While we have not seen the payroll data for September yet (it will be published later today), we believe that the bar for the Fed to wait longer is very high and primarily connected to risks for market turbulence.
2. The US could find itself in a new fiscal cliff situation in early December, when the debt ceiling issue coincides with the need to agree on another temporary funding for the Government as the current financing runs out on 3 December. However, our main scenario is that Democrats cave and solve the debt ceiling issue through a separate reconciliation bill (they do not have to tie this to their larger budget agenda but a reconciliation is still complicated and will take one to two weeks). Democrats do not appear to have a majority for removing the filibuster for the debt ceiling (senator Manchin is against). Republicans will insist that they raise the debt ceiling by a fixed amount, which is what they will have to do in reconciliation, rather than suspending the debt ceiling for another year, which Democrats have proposed.
3. Until the situation is solved, Treasury instruments maturing around a new X date, probably in early December, will trade with a somewhat higher yield. However, if we are right in our assumptions and the issue is resolved in time, another market scare similar to in 2011 and 2013 will be avoided and market movements will be limited. Once the debt ceiling issue is solved, a massive T-bill issuance should put some upside pressure on USD libor vs. OIS spreads and over time contribute to a lower EURUSD XCCY basis spread together with the Fed’s tapering.
4. Democrats can now turn their attention to President Biden’s key agenda, the USD 1.2tn bipartisan infrastructure bill (USD 500bn in new money) and the USD 3.5tn climate and welfare spending, before the new deadline by end-October. President Biden has signalled that he expects the latter to be scaled back to below USD 2.3tn while senator Joe Manchin continues to stick to his demands for no more than USD 1.5 tn.
Our main scenario is a compromise bill around USD 2tn. The stimulus effects for the coming few years depends on how this is done, shortening the length of programmes or cutting them altogether, with spending still likely to be frontloaded.
Rapidly depleting cash balance. At the end of August, the Treasury had USD 95bn of extraordinary measures available and around USD 355bn of cash. The cash balance is depleting rapidly (currently USD 215bn), as new net issuance is not possible until the debt ceiling debacle is resolved. The Treasury has an estimated USD 20bn of Social Security payments due on 20 October, and individual tax refunds of USD 6bn, followed by USD 49bn of payments by 29 October, and a further USD 80bn on 1 November, including USD 14bn of interest payments.
Treasury cash balance at Fed (TGA) & T-bill issuance
Upside pressure on yields of Treasury instruments maturing near the X date. Market uncertainty has increased in recent weeks due to growth anxiety, surging global energy prices, high inflation, China woes, and the Fed’s tapering plans. So far, the debt ceiling deadlock has affected markets primarily by adding to the general uncertainty. The direct effects of the debt ceiling deadlock on rate markets have so far been limited.
Over the past few months, US money market rates have been generally depressed as a result of massive excess liquidity in the fed funds market, due to Fed’s asset purchases (read about the fundamentals of the USD money market in USD money market: Surging volumes in Fed’s reverse repo facility a potential concern?, 28 May). Since reinstating the debt ceiling on 1 August, the drawdown in the Treasury’s TGA account and the ceased issuance of government debt has further boosted excess liquidity in the system, weighing on short rates in general. Since 22 September, the debt impasse has begun to be reflected in the Treasury market, as illustrated by rising yields for T-bills maturing soon after the previously projected X date in mid-October.
Similar moves can be observed in Treasury coupon issues maturing during the same period. On Wednesday this week, prospects of a temporary debt ceiling solution helped to push yields on T-bills maturing in the second half of October substantially lower with the upside pressure in yields starting to build up in Treasury instruments maturing in December.
US T-bill rates: Comparison of three maturities
The chart below shows the still-elevated level of yields on T-bills mostly affected by the debt ceiling debacle.
The upside pressure on yields for instruments maturing in December can be expected to increase until a longer term solution to the debt ceiling is found with risks for more severe market distortions in a run-up to the new X date in early December.
US T-bill curve
Money market in the line of fire. The US has been on the brink of crossing the X date on many occasions previously, but the politicians have always managed to pull out a solution before crossing the critical date.
The historical track record of solving the issue is also the main reason why markets have so far remained relatively calm about risk of missed payments on government debt. As stated by Treasury Secretary Yellen, the US “would likely face a financial crisis and economic recession” if the Treasury’s failed to fulfil its payments on outstanding debt, with very serious repercussions for the global financial system. The severity of such a scenario is the key reason why markets are pricing very low risk for it to happen; we also assume that the default / delay to debt payments can also be avoided.
However, given its systemic importance, the dollar money market stands in the line of fire as the’ X date’
approaches. With money market funds heavily invested in T-bills and important for channelling financing to other short-term instruments, a run on money market funds could jeopardise the availability of credit to corporates in the CP market. While risks to corporate credit availability should be mitigated by massive excess reserves in the banking system, the Fed has previously noted that a large RRP facility could
potentially contribute to financial stability risks by directing money from corporate CPs to RRP facility during times of stress.
After debt ceiling resolution: Wider USD libor vs. OIS spread, lower EURUSD XCCY basis. Once the debt ceiling issue is resolved, the Treasury can be expected to kick-off a massive issuance of T-bills. The rise in cash at the Treasury’s TGA account at the Fed will result in a decline in reserve balances, which can be expected to put some upside pressure on USD libor vs. OIS spreads and mitigate the downside pressure in short USD money market rates in general. Declining excess reserves in the US should contribute to lower EURUSD XCCY basis spreads, which are currently trading near multi-year highs. Upcoming Fed tapering and a likely decline in the Fed vs. ECB’s balance sheet also suggest lower EURUSD XCCY basis spreads going to 2022. Furthermore, EUR issuance has become gradually more attractive, especially at the long end of the curve and November tends to be a seasonally active month for EUR issuance from non-EU corporates. Finally, the year-end effect, with rising demand for USD cash, and generally shaky risk appetite are likely to
contribute to the downside pressure on the EURUSD XCCY basis. Altogether, positioning for lower EURUSD XCCY basis either at the short end (risk-off/liquidity) or further out (strategic) looks attractive.
EURUSD XCCY basis swaps
Euro area: Inflation heading towards 4% and it might not stop there
As economies reopen, Europe has moved from a medical crisis towards an energy crisis, with rapidly surging prices for electricity and natural gas. Indeed, supply shortages of natural gas and sharply higher prices for coal and carbon emission rights, combined with rising demand, have created a perfect storm, triggering an unprecedented upturn in electricity and natural gas prices all over Europe. Rising prices have started to put upward pressure on euro area HICP. According to the flash estimate for September, the energy contribution to the headline inflation rate was 1.7pp, the largest since the euro area was created.
Energy price contribution to headline HICP
The chart below shows examples of gas and electricity prices in the euro area, indicating that both have increased by at least a factor five compared to 2019 20, according to spot and near-term forwards.
Natural gas and electricity, spot and forwards
Uncertain pass-through to consumer prices. Price movements in the energy markets are much larger than for consumer prices, as HICP components also include grid fees, various indirect taxes (excise duty, VAT) and fees from the energy companies. In addition, most consumers have fixed contracts, which delay and smoothen the pass-through. In addition, there are regulations in some countries that set limits on how much prices can increase. Furthermore, several countries announced special measures during the current upturn that will limit the impact from the current price spikes by restricting how much prices to households can increase or by cutting energy taxes to offset the prices rises. France, Spain, Italy and Greece have so far presented different measures to protect households and more are likely to follow. Hence, estimating how large the impact will be on consumer prices is difficult, but to get a sense of the possible scope, we have looked at the historical correlation between the inflation rate for electricity and natural gas versus its spot/forward market price equivalent.
Historical market price movements are almost neglectable compared to the current price increases, which means that the indicated possible impacts on HICP are highly uncertain. However, the chart below (only showing electricity and gas) indicates that the impact could be considerable, with the total energy contribution possibly as high as 2pp. Measures to mitigate the impact on households and forwards implying that prices will decline after the winter will contribute to limiting upward pressure on fixed contracts. Our forecast assumes that the impact on HICP from electricity and gas will rise to around 1pp over the next two quarters, but combined with rising fuel prices, that should still push euro area inflation up to 4% towards the end of this year.
Electricity, gas and the HICP energy component
Upside pressure in inflation expectations; ECB tolerant about high headline inflation. The rising inflation rate has (and will) likely exert further upward pressure on euro area inflation expectations, which is likely to put some pressure on the ECB to withdraw a part of the policy expansion. Still, the Governing Council is very
likely to be tolerant about inflation above the target, especially if core inflation remains subdued, in line with our expectations. Indeed, ECB President Lagarde recently stated that “the key challenges are to ensure that we do not overreact to transitory supply shock”, which supports our case.
Euro area inflation: SEB forecast
High energy prices are a clear downside risk to growth. The rising inflation rate also is a downside risk to growth, as household real income will decline, at least for some time. If energy prices decline as indicated by forwards, average HICP in 2021 and 2022 will be 2.4% and 2.0% respectively. While high compared to the historical trend, real household income will continue to grow, and the difference compared to the assumption in our growth forecast is not large enough to materially change our forecast. However, higher energy prices also constitute a downside risk for the business sector, which, as opposed to the households, is likely to have very little protection from rising market prices. Taken this into account, rising energy prices are a clear downside risk to growth over the next 6 12 months. We see a clear risk for disappointments in growth indicators.
ECB: Avoiding sending policy signals ahead of December meeting
At the September meeting, the ECB carefully avoided sending new signals for the policy in 2022 and yesterday’s account did not offer any new clues on the issue. While a number of comments were presented in both directions concerning the recalibration of the pace of PEPP purchases in Q4, the decision to moderately reduce purchases in Q4 was unanimous on back of somewhat improved medium-term outlook for inflation, higher inflation expectations and accommodative financing conditions. As usual, the ECB repeated that preserving favourable financing conditions remained necessary to support the economy on its recovery path.
Since the 9 September meeting, the sharp increase in the euro area inflation expectations has pushed risk free real rates in the euro area lower, which together with the declining euro has contributed positively to financing conditions. At the same time, inflation pressures have increased and global economic outlook has become more uncertain due to surging energy prices, production bottlenecks and China related woes.
Euro area: 5y EUR real rate and market-based inflation expectations
At its next meeting on 16 December, the Governing Council has to decide on the policy for H1 2022.
According to ECB sources cited by Bloomberg, the bank is considering a new bond buying programme after the PEPP purchases are phased out next year. Such a programme would be in line with our expectations that the ECB will either temporarily boost purchases under the long-standing APP programme or introduce a new temporary post-pandemic programme to facilitate a smooth transition to the post-PEPP era. Altogether, we think the ECB’s market presence next year will be more substantial that what its current decisions are suggesting. Accordingly, we think that the recent rise in short EUR forward rates is not fundamentally motivated.
EUR money market: Front end on the move on excessive liquidity worries
There was a rather noteworthy rise in the front of the EUR curve in September, with a 10bps rise in the EUR 1y1y swap rate. In the first days of October, part of the increase was reversed, but EUR 1y1y still trades approximately 15bps above the current 6m Euribor fixing.
EUR front end: The market is pricing in increasing rates 1y forward
However, future Euribor rates are not only influenced by expectations of the ECB’s deposit rate; the amount of excess liquidity is also a factor. While the ECB deposit rate has been unchanged since September 2019, 6m Euribor is currently nearly 20bps and €STR fixing around 3bps below the pre-pandemic level of end 2019.
The decline has been caused by increasing excess liquidity, which with the transformed hybrid Euribor method has had a considerable impact. It appears that the market is now pricing a notable decline in excess liquidity, which adds to the upside pressure on Euribor futures.
EUR front end: EUR fixings have declined, due to the massive increase in excess liquidity
A comparison of pricing for the coming years shows that the €STR market is pricing a clearly smaller rise in rates than the Euribor market. €STR forwards are pricing an increase of 3bps in the €STR fixing by end 2022, which could in principle just be a roll back of liquidity to the level of January 2020.
EUR front end: €STR futures indicate much lower expectations of rate increases in the OIS market
The 6m Euribor fixing is currently 4 5bps above the corresponding €STR rate. Forwards are pricing the spread increasing to around 14bps in one year, which is 9 10bps above the current level and only 5 6bps below the pre-pandemic fixing spread. We think that the more substantial increase in forward Euribor vs.
€STR rates reflects expectations of declining excess liquidity, but it may also be partly explained by different samples of reporting banks and differences in trimming methods. There are 50 reporting agents to €STR and only 18 for Euribor. Out of 18 Euribor panel banks, 7 are based in Southern Europe. Also, trimming methods are different 25% of the highest and lowest rates are excluded in the calculation of €STR compared to only 15% in the calculation of Euribor). As a result of those differences, there is more inherent credit risk in Euribor compared to €STR, which in the current shaky risk environment may have contributed to the increase in Euribor vs. €STR rates.
Euribor vs. €STR: Forward spread widening in September implicitly prices a reduction of excess liquidity
A reduction in excess liquidity over the next year is a possible scenario. The special TLTRO rate of 1% that most euro area banks have been able to receive is currently set to end in June 2022. If banks are not able to borrow in the TLTROs at a rate below the ECBs deposit rate ( 0.50%), the chances are that there could be a sizable redemption of TLTROs at the following opportunity after June 2022, which would be September 2022. The question is: how much would that affect Euribor and €STR?
However, a lower level of excess liquidity in a years’ time is by no means a done deal. Assuming that the ECB fully utilises its PEPP envelope and continues APP monthly purchases of EUR 20bn, in line with its current plan, it will add around EUR 750bn to excess liquidity by end 2023. Hence, the first EUR 750bn reduction in TLTROs would just take excess liquidity back to its current level. As we have argued previously, we think it is likely that the ECB will rather boost monthly APP amounts, at least initially, in order to facilitate a less dramatic decline in total monthly purchase volumes once the PEPP is ramped down. This means that asset purchases in 2022 may well contribute to excess liquidity more than the ECB’s current plans suggest.
Euro area excess liquidity: Keeps on growing – until TLTROs are redeemed
Furthermore, current liquidity of around EUR 4400bn hides the fact that that euro area governments have accumulated substantial deposits at the Eurosystem: current deposits are more than EUR 300bn above the pre-pandemic level. When governments draw down their central bank accounts, it will contribute to the private sector excess liquidity.
Central government deposits with the Eurosystem
Looking at the relationship between the Euribor vs. €STR spread and excess liquidity in the growing liquidity environment, the most recent almost EUR 1,000bn build-up of excess liquidity has had very minor effects on the Euribor vs €STR spread. While the spread may be potentially slightly more sensitive in a liquidity withdrawal environment, it is hard to imagine that it would lead Euribor vs. the €STR curve to widen by even close to 10bps, which is what forwards are currently pricing .
6m Euribor vs. €STR basis: The basis effects of an increase in excess liquidity above EUR 3500bn has been minor
To conclude, a decline in excess liquidity will affect the basis between the Euribor and €STR curves. This is because the overnight market (€STR market) has the purpose of clearing liquidity, whereas the Euribor market is for longer deposits for which credit risk and regulatory capital considerations play a more
important role. If liquidity is substantially reduced, banks will have to start using market-based funding again.
That will in itself will push Euribor higher (pure supply and demand); on top, the credit spread risk difference between Euribor and ESTR comes into play. As discussed above, we think forwards are pricing an excessive widening of the basis and we look for an opportunity for a tightening position.
EUR/USD: Near-term upside risk especially if oil and gas prices continue to correct lower
EUR/USD has continued lower, although it has moved slightly faster than expected. However, its move lower has been well supported by its fair value, which has been driven almost equally lower due to its rate spread factor. EUR/USD has remained very tight with its fair value but fell close to its 1 standard deviation level at end-September, but this was soon followed by a small correction higher nearly all the way back to its fair value. On 6 October, EUR/USD once again tested for support at its lower 1 standard deviation level and seems ready for another correction higher. So far, all that is indicated by our short-term fair value model is a minor correction towards 1.1660. However, fair value has slowly risen over the past two days and if this continues there could be a larger move on the upside, bringing EUR/USD closer to 1.17 where we rather have expected it.
EUR/USD: Upside valuation pressure and a possible turn in the trend for fair value
EUR/USD: Rate spread factor
What could trigger a setback in fair value? As mentioned, the main component driving fair value lower has been the rate spread factor. As discussed above, rates have been lifted by the sharp rise in oil and electricity prices, which in turn have pushed EUR/USD lower. Oil has corrected lower over the past two days and we could see a larger correction lower as we are at high and sensitive levels as well as the recent development where natural gas prices tumbled after President Putin stated that Russia is ready to help stabilise energy markets and send more gas than contracted to Europe. Gas prices are usually around half of the oil price but have lately been much higher, which has supported oil prices as it may be used as a substitute for gas in many cases; thus, high gas prices have increased oil demand and pushed prices higher. So, a further correction of electricity, gas and oil prices could cause a larger correction higher in EUR/USD.
Oil price & EUR/USD
The Fed and tapering are still ultimate drivers for a lower EUR/USD and, if anything, the temporary resolution of the US debt ceiling removes another obstacle for a November tapering decision and is thus slightly USD supportive. Therefore, we only expect a near-term correction. As we still expect EUR/USD to grind lower longer-term, we believe that a near-term correction higher would be a good level to buy more USD on dips.
Real money value finder
The table below shows yields (YTM) in assorted countries in respective local currency government benchmark bonds and yields from SEK, NOK, DKK, EUR and USD investors’ point of view by accounting for respective currency hedge costs with the aim of providing investors in different domiciles an overview of FX hedged government bond yields. Note that actual relative expected returns over an investment horizon shorter than to maturity will crucially depend on spread movements.
Benchmark bonds: Yield to maturity, local currency and FX hedged
Source: SEB
Summary of macro, fixed income and currency views
Open trade recommendations
Systematic currency strategies
Closed trade recommendations in 2021
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Daniel Bergvall daniel.bergvall@seb.se
Claus Hvidegaard claus.hvidegaard@seb.dk
45 24 60 39 23
Olle Holmgren olle.holmgren@seb.se
46850623268 Elisabet Kopelman
elisabet.kopelman@seb.se
Karl Steiner karl.steiner@seb.se
46 70 3323104
Eugenia Victorino eugenia.victorino@seb.se
65 65050583
Marcus Widén marcus.widen@seb.se
46706391057
