Given that some dust has now settled on last month’s European Central Bank (ECB) action, let’s take a deeper look into the proposed monetary easing measures and the implications for hedge funds.
The four key elements to the ECB package that President Mario Draghi announced last month are the following:
- The interbank interest rate (Euro OverNight Index Average, or EONIA) was cut to zero and the deposit rate cut by a further 10 basis points to -0.4%.
- The quantitative easing (QE) program (whereby central banks inject liquidity by purchasing assets) has been expanded from €60 billion ($68 billion) to €80 billion ($91 billion) a month, although there was no extension of the endpoint, currently March 2017.
- The range of assets included in QE has been expanded to include high-quality corporate bonds.
- A new round of four targeted longer-term refinancing operations (TLTRO) was introduced, allowing banks to access funds at negative rates to lend to their customers. In effect, they are being paid by the ECB to make new loans.
Of all these measures, we believe the latter two are the most significant, and clearly the most novel. One estimate from JP Morgan put the potential resulting expansion of the ECB’s balance sheet at €1.25 trillion ($1.42 trillion).
But will it work? In the long run, it is unlikely that central bank action can create demand by simply supplying liquidity. In the short run, however, the ECB is reacting to the need to foster market confidence, provide support for growth and inflation, and deal with the impact of negative rates on a vulnerable banking sector.
Draghi’s announcement does seem to have squared away some conflicting demands. The hit to the banks from a negative deposit rate has been given a backstop by his statement that rates would not be likely to go lower. Banks have also been given support through being paid to borrow via the TLTRO. The expansion of the balance sheet should be generally supportive for markets.
The extension of the package to include corporate bonds is also notable, and raises the question of whether they might also eventually include equities. At the moment, it appears that it has not been completely ruled out, which represents a change in ECB communications.
One of the main quibbles from investors has been the subsequent strength of the euro, which some observers attribute to Draghi’s comments that further negative rates were unlikely. However, this package was arguably a sign that the focus has moved from currency devaluation to influencing bond yield spreads and providing a jump-start to further bank lending.
The focus has moved from currency devaluation to influencing bond yield spreads and providing a jump-start to further bank lending.
Hedge fund opportunities
These new measures represent opportunities for hedge fund managers, especially those who use credit strategies, as the most interesting dynamics are occurring in the corporate bond markets. We have already seen prices rise across a range of cash and synthetic credit products (otherwise known as derivatives) as well as a record amount of euro-denominated investment grade corporate bonds issued in the week after the announcement. For the time being, bond prices are likely to be heavily influenced by fact that the ECB is now a large buyer in the market. In order to stay ahead of movements, the other market participants will try to anticipate “in-scope” and “out-of-scope” securities under the corporate bond purchase program.
The medium-term impact of the ECB’s actions is less clear. While stabilization in the European corporate bond markets is one of the goals and could lead to further high yield and bank capital issuance, bouts of volatility may persist due to risks in the European financial sector and other external macroeconomic factors. Should the ECB prevail though, continued high-yield bond issuance could present a growing opportunity set for nimble long/short credit managers to trade when there is mispricing.
Depending on how successful the ECB’s QE measures will be at mitigating the risk of extreme events, credit funds with a geared exposure to the market could once again see this as a driver of returns. Structured products such as residential and commercial mortgage-backed securities (RMBS and CMBS) and collateralised loan obligations (CLOs) could see a gradual improvement in pricing, having experienced a very volatile start to the year. Managers that specialize in these less well-understood asset types may find a better entry point today than 18 months ago, albeit in an environment where liquidity has deteriorated.
Bank deleveraging (debt reduction) is also expected to continue in Europe, driving a range of opportunities but also risks. Opportunities include going long or short in senior and subordinated bank debt. However, financial sector deleveraging impairs liquidity in the marketplace as banks shrink their balance sheets and as their risk appetite for credit wanes. The possibility of a disorderly deleveraging cannot be discounted.
More cyclical credit strategies may find their opportunity set diminished because of the ECB’s actions. We were anticipating that interest in distressed debt funds could pick up as the credit cycle progressed, throwing up opportunities as companies started to struggle to finance their debt or defaulted (as hedge funds can take short as well as long positions). However, the ECB’s actions may have pushed the timing for an increase in distressed corporates out further – default rates will probably not pick up materially in the near future as treasurers of highly indebted companies take advantage of the lower rate environment to kick the can down the road through opportunistic issuance and pushing out the maturity of their debt.
For equities, there is a range of interesting dynamics. One long-short equity manager commented that the continued repression of bond yield spreads will be helpful for the more defensive companies which see their share prices influenced by bond discount rates. The ECB actions should also clearly be helpful for banks, although we observe that those who have exposure to this area were invested prior to the announcement on fundamental valuation grounds.
While the ECB action is clearly supportive, it does not indicate a major regime change.
Another manager outlined that if there is a positive impact on GDP growth and some euro weakness, this will be helpful for operational results for European companies. However, the former is still in question and there has been limited evidence of the latter so far.
While the ECB action is clearly supportive, it does not indicate a major regime change. The best course of action may indeed be to sit tight and be patient.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
There are special risks associated with selling securities short. A short position will lose value as the security’s price increases. Theoretically, the loss on a short sale can be unlimited.
The use of leverage will also increase market exposure and magnify risk.
Derivatives entail risks relating to liquidity, leverage and credit that may reduce returns and increase volatility.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment) and credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral).