Rates Spark: The finer details

Around the middle of the European sessions, EC president von der Leyen is due to present the commission’s blueprint for a joint EU recovery fund. Consensus is, in our understanding, for the plan to have a lot in common with the French-German proposal from last week. If we agree that common EU issuance and the prospect of some degree of fiscal transfer is a potentially significant precedent, the plan raised more questions than it answered. Note however that this plan fires the starting gun on negotiations between the 27 member states, and that there is no telling for sure where the common ground may be. The German deputy FinMin said overnight there is room for compromise with the 'frugal four' member states.

Some of these questions may be addressed today. Central to whether the plan entails a meaningful degree of fiscal transfer, and therefore reduces the risk of economic divergence between member states (MS), are the total amount of grants, and the distribution key. An analysis published by the ZEW institute sees a net benefit of €19-26bn for Italy (see chart above). Remember transfers would likely only start in 2021 and be spread over more than one year. Note also that the money disbursed would not necessarily be a substitute for what recipient governments would have spent money on, and therefore would not automatically reduce their deficit or government bond issuance.

We have argued before that ECB easing is a more potent and immediate tool for easing pressure on EGB markets. Consensus has converged on an increased PEPP target to be announced as early as next week. When one factors in sizeable skew in favour of Italian bonds, if PSPP is any guide, this should provide enough impetus for further sovereign spread tightening. Schnabel and De Guindos were the latest officials to speak. The former repeated the ECB was ready to adjust its tools 'if necessary'. De Guindos said abandoning the capital key in PEPP purchases hadn't been discussed.

With the question of sovereign liquidity all but settled by the ECB, and some baby steps taken towards a more complete set of bailout measures (ESM, SURE, recovery fund) we think investors will feel more comfortable with adding carry exposure in higher beta fixed income. Whether this pushes core bond and swap rates higher is an open question but we continue to lean towards the negative. After all, only if PEPP data shows the ECB has deserted core bond markets, in particular Germany, do we expect a significant knee-jerk rise in yields. There is also the ongoing risk of a rise in geopolitical tensions with China helping maintain rates low. Overnight, Trump promised sanctions in response to the Hong Kong security law and the EU said they will address the issue soon.

USD 3mth Libor bottomed two days ago at 36bp. It has since edged back to to 37bp. It's just a basis point, but it is threatening to morph into a new mini-trend. Libor overshoots can begin with mild basis point moves, so should we be worried? Not at all in our opinion, at least not based on what we know.

In fact we'd argue, if anything, that 3mth Libor had overshot to the downside too quickly. It is true that we identify the 30bp area as a natural area for 3mth Libor to end up at. But we also felt that the break below 50bp, and then below 40bp was beginning to understate systemic risks, and in particular default risk that lies ahead.

In that respect, the edge higher in 3mth Libor makes a degree of sense. But rather than it being a point of concern, it is more indicatice of Libor converging on a better fair valuation. The fact remains that the Fed has had the luxury of paring back support to the domestic system, and moreover has not had to make use of the exceptional support that could be unleashed.

So we are watching carefully. We would not be surprised if it edged higher still to the 40bp area. If it did there is no need to panic. It is still down over 100bp from where it was at end March, and back then there was no doubt a material discount for systemic angst. That is not there now, and it does not need to be.

Lagarde’s participation in the #AskECB event might be the scene of more dovish soundbites but, given already high QE expectations, we think the most prominent risk scenario is one of a misinterpreted hawkish comment. Her deputy is also due to speak although recent interventions reduce the odds of surprises.

France mandated banks for the launch of a 20Y OAT which we think should price today. Its most recent syndicated deals, both 30Y bonds, raised €7bn and €5bn respectively. Increased borrowing needs warrant a larger size today in our view.