French election: Euro wins

Mid-Week Bond Update

French election: Euro wins

Emmanuel Macron’s victory in the first round of the French presidential election helped lower the geopolitical anxieties overhanging capital markets, but...

...caution remains elevated. Benchmark 10yr U.S. Treasury and 10yr German bund yields moved higher, but not in dramatic fashion; both remain below levels of a month ago. Meanwhile, French, Italian and Spanish sovereign yields declined as the Macron news sparked some “risk-on” sentiment, seen especially in the high yield and emerging market sectors, which were among the biggest gainers over the past week. Improving economic data from Europe suggests the ECB may soon begin laying the groundwork to embark on policy normalization. Meanwhile U.S. economic data has softened and inflation expectations remain low—but that didn’t stop expectations of a Fed rate hike in June from increasing from 50% to 66% following the French election.  The euro gained 1.3% versus the U.S. dollar on Monday following the French election and is up 2.1% over the past week. Sweden’s krona was another notable currency gainer versus the dollar over the past week—its 1.6% advance was driven in part by the government’s growth upgrade for this year to 2.6%, but the currency is still 3% below a recent high in February. Among emerging markets, Eastern European currencies generally strengthened against the U.S. dollar over the past week, while Latin America currencies traded lower and Asian currencies were mixed. 

 

On the rise

Macron and the euro—stronger together On Monday, the euro closed at $1.087 versus the U.S. dollar, up 1.3% on the day and 4.6% above the recent low of $1.04 on 12/20/16. Monday’s gain was the biggest daily percentage gain for the euro against the U.S. dollar so far this year. The jump came the day after French voters gave the first round of the presidential election to Emmanuel Macron—whose political currency has also strengthened. He’s now considered the favorite by a wide margin to win the May 7th runoff against Marine Le Pen – whose anti-EU rhetoric has worried investors with a stake in the union’s stability. Election results so far this year certainly seem to have reduced uncertainty in the region – bear in mind that the 2nd biggest gain for the euro vs. the dollar came on March 15, when Dutch voters rejected anti-EU candidate Geert Wilders—but there’s more than just politics at play. Recent economic data has also been solid, suggesting the region’s economy could be gaining momentum as well. More volatility is not out of the question though—more elections lie ahead and economic data is always choppy. Active bond managers remain on alert for opportunities.

 

Macron first round win was euro-positive

Euro/dollar spot, daily percentage change: 1/2/17 – 4/24/17

Source: Bloomberg as of 24 April 2017. Please find definitions in the disclaimer.


Europe’s economy–Building confidence Economic data is improving in Europe, and if that continues, it could encourage the ECB to move toward a neutral stance on rates—perhaps as early as this summer. Last week, Eurostat reported that construction spending for February increased 6.9% from January, the largest month-to-month rise since March 2012; it was up 7.1% from a year earlier, the best 12 month gain in nearly 3 years. Also, the Eurozone manufacturing PMI for March rose to 56.2, the highest level since April 2011 and a preliminary measure of monthly consumer sentiment for April tied its best level since mid-2007. It’s no surprise that analysts recently raised 2017 profit estimates for European companies for only the second time in a decade. With the growth outlook firming and deflation risk all but gone, the markets’ focus will turn toward how and when the ECB will start to normalize monetary policy. An abrupt shift may be unlikely; as the U.S. Fed has discovered, reining in stimulus without market disruption is a potentially tricky business.

 

On the slide

Sovereign spreads–Macron “risk on” Safe-haven 10yr German bund yields rose 14 basis points (bps) in the 5 days ending 4/24/17, half of that coming on Monday following the first round of the French presidential election. Meanwhile, French, Italian & Spanish 10yr sovereign yields declined over the same time period, resulying in tighter spreads with German bunds. That’s a sign that the markets viewed Macron’s win as a positive development for the region, in part due to his reported support for expanded free trade, lower taxes and more labor market deregulation. French 10yr sovereign yields fell the most (11bps) on Monday with the yield spread to bunds tightening by 18bps. Italian and Spanish yields fell about 8bps with spreads tightening 15bps and 16bps respectively. Yet these sovereign spreads remain above last year’s lows. The “risk-on” spirit was also seen in the corporate bond sector. The Bloomberg Barclays Pan European High Yield Index OAS tightened by 20bps to 337bps, the lowest level in nearly three years, but that’s still 150bps above its pre-crisis of 184bps in June 2007.

 

Sovereign spreads tighten in wake of Macron’s first round win

French, Italian & Spanish 10yr sovereign spreads to 10yr German bunds

Source: Bloomberg as of 24 April 2017. Please find definitions in the disclaimer. 


High yield—default rates sink Moody's expects its global speculative-grade default rate to fall to 2.5% by the end of the year, down from 3.8% in March 2017. That would be well below the 4.3% historical average since 1983. The default rate was 4.5% at the end of 2016, but is improving quickly as the market cleanses the most levered credits, mostly in energy and commodities, that defaulted heavily in 2016. In the U.S., the trailing 12-month par-weighted high yield default rate was just 1.9% in March, down from 3.32% at the end of 2016; excluding energy it was just 0.64%. Western Asset—certainly cognizant of the political uncertainties in the U.S. and abroad—continues to believe the average high yield issuer is in fundamentally good shape, noting that corporate earnings are improving, revenue generation is on the rise and interest coverage remains elevated, while leverage approximates long-term averages. While new issuance was $80.3 billion in 1Q17 (up from $47.3 billion in 4Q16 and up from $31.7 billion in 1Q16) Western notes that net new issuance (which accounts for redemptions and refinancing) was a mere $119 million for 1Q17—and they believe the quality and purpose of issuance is a positive for today’s market, but also suggests that the positive credit cycle could continue into the future.


Source for all data: Bloomberg, Western Asset as of 24 April 2017, unless indicated.

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