MARKET MOVER - BNP PARIBAS - Investment Services India

EUR: Outlook for the Curve
• The Fed has clearly opened the door for
QEII. QEI was favourable for govvies and
mortgages but also for equities as the liquidity
bonanza supported risk appetite.
Chart 1: QEI Supported Stocks and Bonds
• Things are different this time, with
significant implication for the curve – especially
after the recent sell-off.
• STRATEGY: Short the curve on the 5-10y
segment.
The prospect of more liquidity
The latest FOMC statement made it clear: the Fed is
on the verge of resuming quantitative easing. It is
worth noting that when the Fed conducted QEI in
2009, this allowed both bond and stock markets to
perform well. Indeed, in addition to direct purchases
of debt by the Fed, easier and larger liquidity
supported risk appetite, boosting risky assets such
as commodities and equities. One can therefore
regard the prospect of QEII as providing firm support
for all classes of assets. Of course, the size of
purchases matters when it comes to the impact of
QE. The Fed will have to buy a lot in order to bring
about lower yields and tighter spreads. In the
eurozone, the ECB is only extending non-standard
conditions for tenders and continues to buy small
quantities of sovereign bonds. But the outlook for
coming months is that liquidity will remain ample.
Big difference with 2009
The backdrop for QEI was very different from the
current one. When the Fed started purchases in
2009, the economic outlook was for recovery and
reflation. This is far from the current situation. Signs
of pronounced weakness in the US economy are
mounting, and the euro area is not protected against
a slowdown. In addition, in both areas, the outlook for
inflation is to the downside. Upcoming data should
confirm that core inflation continues to ease. As a
result, upcoming quantitative easing may be less
favourable for riskier classes of assets, in particular
stock markets. This will have major implications for
the curve, particularly after the recent sell-off.
The curve in coming weeks
The strong rally that occurred during the first two
months of summer was almost completely led by the
back end of the curve. Strong receiving interest
dominated, leading to lower long-term yields and a
flatter curve. The sell-off that took place during the
first half of September was more broadly based
across the curve. Indeed, the short end suffered
Source: BNP Paribas
Chart 2: Market Direction and the Curve
Source: BNP Paribas
significantly, preventing the curve from resteepening
strongly. The question is now whether or not the
resumption of a bullish tone will trigger flattening
pressures.
The sell-off at the short end of the benchmark curve
was linked to risk appetite, which favoured stocks
and weighed on short-dated sovereign debt. Against
this backdrop, if the bullish tone in EGBs goes along
with solid equities, the curve will flatten from the 2y
area as risk appetite will prevent the short end from
rallying. But if upcoming data point to worsening
economic conditions, stock markets will suffer and
the short end will enjoy a decent rally as well. Near
term, we consider the latter situation as more likely.
As a result, we see the bullish tone developing along
with flattening pressures starting only from the belly
of the curve (5y area).
Strategy: Short the curve on the 5-10y.
Patrick Jacq 23 September 2010
Market Mover, Non-Objective Research Section
24
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