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Central banks to the rescue

While expecting long-term yields to be capped, we remain neutral on US Treasuries. We think peripheral euro area bonds to avoid the levels of stress seen during the sovereign debt crisis.

On 23 March, the Fed announced unlimited quantitative easing (QE), or “QE infinity”. Ramping up its purchases of Treasuries to a daily pace of USD75 bn, it currently owns 18% of all US Treasuries outstanding, but could easily own between 40%-50% by the end of the year. We remain neutral on US Treasuries, expecting the 10-year yield to remain around 0.7-0.8% over the coming months, but rebounding slightly above 1% in H2 as economic activity picks up. A sharper rise is unlikely in our view, as the Fed will probably cap long-term yields through its QE purchases.

On 18 March, the ECB unexpectedly announced the creation of a Pandemic Emergency Purchase Programme. Taking into account our projected PEPP and Assets Purchase Programme purchases and the increase in net issuance linked to covid-19 stimulus measures, the ECB could end up owning 34% of German, 22% of French, 21% of Italian and 27% of Spanish total sovereign debt outstanding by end 2020.

For now, we are maintaining our existing 10-year Italian and Spanish spread forecasts, expecting further tightening to around 130bps and 80 bps over Bunds by year-end, respectively, compared to 201 bps and 135 bps on 1 April. We remain neutral on peripheral sovereign bonds, expecting that between the ECB’s intervention and euro area fiscal solidarity (be it through an EU coronavirus rescue fund or the issuance of coronabonds), peripheral bonds will avoid the stress experienced during the euro sovereign debt crisis of 2011-2012.

We expect US high-yield (HY) and euro HY default rates to increase sharply by year’s end, to 15% and 6%, respectively. As such, we would expect HY spreads to remain elevated in the coming months. However, as economic activity picks up again in H2, we think spreads will come down, despite a continued rise in default rates. Given the economic uncertainty and the likelihood of wider spreads in the short term, we remain underweight both US and euro HY, not yet seeing wide spreads as an entry point to add exposure to risky issuers.

Both the ECB and the Fed now will be important players on the IG corporate bond market. We believe the Fed could end up owning about 7% of the US IG universe, and the ECB 15% of the euro equivalent. While significant, this presence may not stop a large wave of ‘fallen angels’. For these reasons, we continue to be defensive on credit for now, remaining neutral on US and euro IG. We are looking for opportunities in the highly rated segments and favour companies with low net leverage ratios, ample cash and limited exposure to covid-19 disruption.

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