Markets prepare for rising rates as Draghi recalibrates

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When rates start to rise, the big action will be in credit markets. Banks are already staffing up amid efforts to unfreeze the market structure and make it easier to take on and lay off risk

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Mario Draghi stuck pretty much to the script sell-side analysts and buy-side economists had already written for him.

On October 26, he extended the European Central Bank’s bond-buying programme to September 2018 – or perhaps even further – but with net monthly purchases to be cut from $60 billion to $30 billion. There was not even a ghost of a smile when he called this recalibrating instead of tapering.

Operating in full on-the-one-hand up, on-the-other-hand down mode, Draghi expressed confidence that inflation will return to the ECB’s target of just under 2%. Just don’t expect that to happen soon: the ECB forecasts inflation of just 1.5% for 2019.

He cautioned that the ECB will continue to re-invest proceeds from maturing securities long after net purchases end, while yet boasting that the ECB’s latest data and survey results point to unabated growth momentum in the second half of this year and that recent sentiment indicators could point to further positive surprises.

Market participants take as much of this on board as they are predisposed to.

Azad Zangana, Schroders’ senior European economist, now expects the ECB to extend quantitative easing again towards the end of next year, ahead of finishing the programme in December 2018, paving the way for a rise in interest rates in the first half of 2019. Philippe Gudin and Antonio Garcia Pascual, economists at Barclays, see the door open for an increase in the deposit rate of 20 basis points as early the fourth quarter of 2018.

Play scheme

This doesn’t strike Euromoney as much of a big deal, but the signs in the banking industry show preparations are being made today, albeit at one remove from the rates market where one might expect the action.

“How will this play out in the government bond markets?” one banking source repeats back our question. “Ah, I remember the days when we used to have a government bond business. We now have a high-yield bond business instead: a decision that was taken for us in Basel.”

While investors in the rates market remain complacent, it is the credit markets that we should watch most closely when the rates markets start to gyrate.

Deutsche Bank last month announced a number of hires across its credit business, including a new global head of investment-grade credit trading, Paul Huchro (a former Goldman partner no less), who also takes on the position of head of high-yield credit trading in the US and Europe.

Over the last 18 months, the German bank has made 40 hires in US and European investment-grade bond sales, trading and research. Part of that is simply replacing staff who quit as morale plunged over bonus bans and the vast legal expenses that at times have called the bank’s continued independent existence into question.

Deutsche Bank had fallen particularly in flow credit. It wants to claw its way back now in expectation of increased client activity as rates rise in the years ahead.

The action is boiling up in plays on credit market structure.

Time for action

Just two days before Draghi recalibrated, Intercontinental Exchange, a leading operator of global exchanges and clearing houses, agreed to acquire Virtu BondPoint from Virtu Financial for an eye-popping $400 million in cash. It is a huge price to pay for a bond e-trading platform offering the buy and sell sides access to centralized liquidity and automated trade execution.

Euromoney reports elsewhere on the agreement of BNY Mellon, the world’s leading custodian, and HSBC, to allow Algomi to ping alerts of trade activity and indications of interest to custody clients that might be relevant to their bond holdings.

The prospect of rate rises is adding new urgency to industry efforts to make more of the vast inventory of illiquid credit bonds potentially available to trade.

The hope is that, if bank dealers can open up various pathways to other dealers, asset managers and the vast stores of bonds held in custody where they might find off-setting trades, they might be more willing to take on risk and so facilitate its transfer for investors.

If these efforts to unfreeze the credit markets ahead of rising rates founder, the pain may spread beyond bond investors.

As Michelle Neal, chief executive of BNY Mellon Markets, points out: US companies rely on the corporate debt market for funding more than any other globally.