MARKET MOVER - BNP PARIBAS - Investment Services India

This section is classified as non-objective research
EUR: Liquidity Spread Compression at an End
• The recent decisions taken by the world’s
major central banks, many of them expected,
have eased volatility. Liquidity is benefiting in
this environment and spreads have tightened
significantly.
• At current levels, as the good news is
behind us and adverse events potentially lie
ahead, we think we could see limited spread rewidening
in the coming weeks.
• Strategy: Paying interest on spreads makes
sense now.
Chart 1: Less Stress Helping to Tighten Spreads
Central banks have further eased stress
The decision by the ECB to announce its OMT bondbuying
programme was, for the most part, expected.
However, some of the elements it announced, such as
the potentially unlimited scale of the purchases and the
bank’s waiver of seniority, were very well received. The
moves highlighted the commitment of the ECB to do
whatever is necessary to safeguard eurozone
sovereign debt eligible for OMT buying. The
combination of potential ESM buying in the primary
markets and the ECB’s intervention in the secondary
markets will, without doubt, improve liquidity conditions.
The Fed’s decision to launch open-ended QE, in
addition to pursuing Operation Twist, paved the way
for additional liquidity extension in the US.
The main impact of these decisions has been a sharp
decline in volatility and signs of liquidity improvement.
As a result, risk appetite has rebounded strongly,
offering support to equities, commodities, and weighing
temporarily on safe havens. As liquidity conditions are
set to improve, liquidity-driven spreads have
compressed significantly. This is evident in the money
markets (OIS/BOR spreads at lows) and bond markets
(cheapening of benchmark paper in ASW terms).
Back to reality
The spread compression as a result of this latest
monetary action has been sizeable, but the moves
have now been priced in and their impact is likely to
fade near term. The fundamental backdrop is set to
be a key market driver in coming weeks. Very weak
economic data in the eurozone are likely to be a
trigger for significant market reaction – and this
favours risk-averse behaviour. In this context, we see
room for a further decline in yields on benchmark
paper, as their safe-haven status is likely to attract
Source: BNP Paribas
flows. We expect the 10y Bund to rally from 1.70% to
1.58% in the week ahead and we could see a
rebound to closer to 1.40%. This will go hand-in-hand
with a flatter benchmark curve and wider spreads.
Upcoming adverse events
In addition to the economic background, several
upcoming events are expected to fuel upward pressure
in the gamma space. Budget presentations and
warnings or negative moves by the ratings agencies on
sovereign debt are among the many factors that could
weigh on risk appetite. Political developments may add
to this bias. Local elections in Spain, in particular, are
likely to be a cause of volatility.
With volatility rising, liquidity conditions are exposed
to deterioration. As a result, we see scope for wider
spreads where they are linked to liquidity conditions.
This is the case for ASW spreads, second-tier core
spreads versus benchmarks and OIS/BOR spreads.
When it comes to ASW spreads, we see room for the
10y Bund to richen in ASW terms, from 22bp at the
moment to the 30bp area. As far as second-tier core
markets are concerned, the 5y area has richened
significantly over the last couple of weeks. We see
some risk of a setback in this area.
OIS/BOR spreads, meanwhile, are now back to precrisis
levels. This looks overdone, and we see scope
for corrective re-widening.
Strategy: Sell the 10y Bund/swap spread at -22bp,
with a target of -30bp. Buy the 5y OBL vs. France,
Austria and Belgium. Pay OIS/BOR spreads at 15bp,
with a target of 18-20bp.
Patrick Jacq 20 September 2012
Market Mover
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