Adam Smith believed in the invisible hand, meaning an economy works best in a free market scenario with participants acting in their own interests. More than 200 years later, Central Bankers thought differently. In the aftermath of one of the worst financial crises in history, Central Banks have taken significant unconventional measures primarily by reducing base rates and buying fixed income securities in order to lower borrowing costs and hence stimulate demand. Today, after nearly eight years, global growth and inflation are finally picking up, reducing the need for ultra-accommodative monetary policies. Can Central Banks pull back from the market without creating a hiccup or is continued monetary stimulus the new norm?
Today, the Fed is the first Central Bank to unwind its unconventional monetary policy. So far the results have been mixed. When it announced in 2013 that it would start ‘tapering’ its bond purchases, investors panicked and fixed income markets lost -4%¹ over two months. However, since December 2015, when the Fed first raised the Fed Funds target rate, the market reaction has been fairly muted. One of the lessons learned from the Taper Tantrum is that Central Banks need to telegraph their actions well in advance. As such, markets are carefully watching the Fed’s plan on when and how they will stop reinvesting their huge portfolio of government bonds and agency-mortgage backed securities of USD 4.5 trillion².
As the European economy follows the footsteps of the U.S., the ECB is preparing market participants for less quantitative easing. Indeed, improvements in the unemployment rate and signals from surveys such as PMIs suggest that ultra-accommodative policy is no longer required. In March, the final Targeted Longer-term Refinancing Operation (TLTRO II) operation was conducted and this month, the ECB is reducing its monthly purchases of its Asset Purchase Program (APP) from EUR 80 billion to EUR 60 billion.
No one knows for certain when the next downturn will hit, but there are few immediate warning signs. However, it seems increasingly likely that Central Banks will still have some level of easing in place if another crisis happens in the near future, as it will take several years to normalise their balance sheet. This poses the question to what further actions Central Banks can take and how effective they will be.
How could fixed income investors position their portfolios when the visible hand retreats from the market? U.S. agency-mortgage backed securities and Treasuries look vulnerable because we expect the Fed to hike rates at a more rapid pace than priced by the market and to stop reinvesting their bond purchases later this year. Equally, Eurozone government bonds and investment grade corporates might feel the pain as the ECB, the largest buyer of these securities, is gradually reducing its purchases. Instead, bonds that provide a high level of carry without much duration risk look relatively more attractive. As such, high yield bonds, particularly USD-denominated, look best placed as credit spreads generally compress in times of rate hike cycles. Moreover, higher yielding corporate debt benefits from the improved growth environment which should support corporate earnings, decrease leverage and reduce the probability of defaults.
¹Source: Bloomberg Barclays US Aggregate Total Return Index. Data from 2 May 2013 to 24 June 2013.
²Source: Federal Reserve Quarterly Balance Sheet Development Report. March 2017.
The French election is the major upcoming political risk in Europe. The markets are concerned about a possible Marine Le Pen victory as one of her key campaign promises is to hold a referendum on France exiting the euro currency bloc. The departure of one of the Eurozone’s leading countries would most likely lead to the breakdown of the Eurozone. The instability created by Brexit as well as anti EU rhetoric from Trump and others exacerbates the probability of a Frexit.
Since the end of 2009, the Eurozone has undergone periodic economic crises. Initial cracks in the economic well being of the region first appeared post the 2008 global financial crisis, when concerns arose about the ability of the peripheral countries to meet their debt payments, notably Greece, Spain, Portugal, Italy and Ireland. Marine Le Pen’s victory would undoubtedly lead to a deep political and economic crisis in the Eurozone.
Investors head into this current event with some concerns: What are the odds for this tail risk to materialise? Does Marine Le Pen’s victory mean “Frexit”? How has the volatility of the French OAT yields and their correlation with the other members of the Eurozone evolved since the Eurozone crisis?
There are five candidates for the presidency: Marine Le Pen (Eurosceptic and anti-immigration), Francois Fillon (Center-right), Emmanuel Macron (Center), Benoit Hamon (Socialist) and Jean-Luc Melenchon (Socialist). The first round of the election is the 23rd of April and if no candidate gets above 50% of the vote, there is a second round two weeks later between the top two candidates.
In the last few months, three events could have increased the probability of Le Pen‘s victory:
None of these events ended up happening, and the first round debate last week was dominated by Macron, so the market now expects Le Pen and Macron to win the first round the 23rd of April, and Macron to win the second round which is happening the 7th of May. On the back of this, the market has been reducing their risk hedges. In most polls Macron leads Le Pen by 20% in the second round, which seems like a big gap to close one month before the elections. However, the ramifications of a Le Pen victory are so significant that it is worth taking it seriously.
Are correlations telling us anything?
Correlations so far are telling a tale of a gradual deterioration of the French fiscal picture – France shifting from “core” to “semi-core” – rather than of a risk of a Eurozone break-up.
Before the Eurozone crisis, the correlation matrix showed us that all spreads across the Eurozone were moving together, as a bloc. During the Eurozone crisis, looking at Q4 2011, we can see a clear demarcation between the peripheral countries, and the “core” countries. France, a “core” country at the time was very highly correlated with Germany, and lowly correlated with the peripheral countries.
In recent months we have seen that the correlation between the Bunds and the OAT has decreased substantially (from 0.92 during the crisis to 0.59 now), and the correlation between France and the peripheral countries has increased substantially. The dynamic shows that the market considers the current situation for France to be similar to the situation faced by the peripheral countries in the event of a Le Pen victory.
In the near future, no matter the outcome of the elections, it seems unlikely that France trades again like a core country, given that the election has brought renewed focus on issues the country faces, such as its big deficit and its need for reforms first.
What if Le Pen wins? Does it mean Frexit?
There are two main scenarios if Le Pen wins:
What does Frexit mean?
Frexit would create balance sheet stress and solvency challenges. Under the tail scenario, there would be a FX redenomination and a new yield curve which would likely lead to higher yields in French bonds. This is a big risk given the fiscal deficit in France.
European investors will face two main risks:
This is a tail scenario which remains a very unlikely event, but it has important ramifications so it should not be overlooked. It would be too complacent to think that in the case of a Marine Le Pen win in the presidential elections, parliament would completely stand against the Front National’s willingness to leave the Eurozone. The signal sent by the French people would indeed be very strong and rules and laws can always be changed or circumvented. There would be “sword of Damocles” above the Eurozone, its institutions, and all European assets. As we have seen in previous elections, outcomes that start off as unthinkable, and then appear unlikely, can go on to become reality.
J.P. Morgan Asset Management does not predict outcomes of any political events, nor do we voice firm-wide opinions on any political candidates.