Monetary divergence is back on track

After mixed signals from the Fed over October, Yellen declared that a rate hike was still a "live possibility" for 2015 during the Congressional Testimony early November. She added that the start of the rate hike cycle remains data dependent. As a result, after good labour data - Non-Farm payrolls (+271K) largely exceeding expectations (+185K) - market participants have now strong confidence that a rate hike will intervene in December.

On the other hand, M. Draghi clearly opened the door for more easing, by indicating that a QE expansion was an option but also by removing the zero lower bound labels from the deposit rate's current level of -20bps. The Bank of England remained also dovish pointing out that global growth could be further lowered and UK inflation would pick up only at a slow path.

In this context, the sovereign debt markets are driven by opposite forces: a hawkish Fed and dovish ECB and BoE. Thus, we prefer to underweight the US yield curve on the 5- and 10-year buckets while we overall favour European debts, especially the non-core EMU area. Directionally, we remain neutral on the back of expensive valuation signals (the German curve is in negative territory up to the 5-year maturity).

Positive non-core but neutral on Portugal

As mentioned above, we remain overweight on the non-core area on the back of accommodative monetary policy, at the expense of the core area. From a macroeconomic point of view, thanks to buoyant private consumption, EMU Composite PMI rose to a firm 53.9. Labour data are also improving with unemployment rate in the region declining to 10.8% versus 11.5% a year earlier. Moreover, interest rates on loans are declining further, especially in the peripheral economies (Chart 2). Housing market in peripherals has probably bottomed-out in Spain while in Ireland and Portugal housing prices are increasing. Among non-core countries, Italy is our preferred position, driven by better liquidity and flow dynamics as well as lower political risk. We closed our overweight on Portugal due to heightened political risk. The appointment of a left government could also reverse certain austerity measures.

We reinitiated a positive strategy on linkers

Inflation is not anymore in negative territory (0%) and still far from the inflation target of the ECB (2%). Considering the upcoming base effect, we see inflation grinding back to 1% next year, but to remain below target. As a result, Draghi will probably have to increase his accommodative stance. At depressed levels, we thus initiated a positive bias on inflation linked bonds given that carry dynamics are positive and inflation premium is limited (Chart 3).

 

 

CURRENCY STRATEGY

Short EUR / long USD

From April to October, the EUR/USD cross broadly stabilised within the 1.10-1.15 range on the back of a US Federal Reserve unwilling to enter a rate hike cycle in a risk-off environment. But while EM and Chinese economic risks faded somewhat and US labour data proved their strength, the Fed finally gave hints that a rate hike could occur before year-end. In the meantime, Draghi continues to show signs of concerns regarding the inflation expectations and the strength of the EUR which can impede the rebound of the inflation figures. Both stances illustrate the monetary divergence between the Fed and the ECB. As a result, we have a negative view on EUR and a positive one on the USD.

 

Long JPY

We like Yen despite the recent economic slowdown. According to our framework, long-term signals indicate that the JPY is in attractive territory (partly due to cheap Purchase Power Parity valuation). Investors are deeply short the currency but the trend is reversing (Chart 4), giving it an important rebound potential. Also, the JPY conveys a safe haven status in a risk-off context. Lastly, the BoJ remains confident that its easing programme will be sufficient to boost inflation towards its 2% target.

Cautious on many EM currencies

As mentioned in our previous edition, we anticipated that the EM currencies rebound initiated early October was globally temporary and technical on the back of a prudent Fed which weakened the US dollar. Since November, many currencies depreciated again partly due to the changing tone of the Fed.

Given the Emerging slowdown and the end of the commodity super-cycle, we thus remain negative overall on Emerging currencies. We hold an overweight on US dollar on expected further CNY weakness (via underweight on MYR, KRW, THB). Regarding the MYR, the deterioration of endogenous economic parameters (accelerating FX reserve losses, ongoing political scandals) and the lower oil and gas prices are painful for Malaysia.

We are also underweighting commodity-linked currencies such as the COP and RUB. Peru is facing low growth and a high current account deficit. Last but not least, the Central Bank is allowing currency depreciation as an adjustment mechanism.

Yet, we have also positive long-term convictions for few currencies. The INR will be supported by the good reform momentum and the PHP by the solid fundamentals. We also turned positive on TRY: the victory of the ruling party led by President Erdogan during the last legislative elections eliminated the risk of earlier elections and the risk of extended negotiations between parties to form a government.