GLOBAL CREDIT BULLETS | Monday, 11th July 2022

European energy – Shutdown fears
Market fears of a potential shutdown of Russian energy have intensified over the past week. The NordStream 1 pipeline, Europe’s single biggest piece of gas import infrastructure, will shut down for maintenance starting today, and it’s supposed to go back online on July 21st. Given the recent drop in energy flow and the ongoing gridlock in Ukraine, markets are concerned about Russia not allowing gas to flow back to Europe at the end of the maintenance period, deepening the European energy crisis. Germany’s economy minister Habeck has made these concerns public this week, increasing the uncertainty. Overall, Europe imports 40% of natural gas from Russia, the majority of which via the NS1 pipeline. Gas flows towards Europe have dropped substantially over the past few months, as the rapid increase in price allows Russia to reduce supply as political stick without harming revenues. Current flows to Europe are 60% of pre-war levels, having been closer to 90% in the first few weeks post invasion. Germany and Italy are most exposed to the shutdown risk, as they have highest share of flow and lowest storage in Europe. Flows towards Germany are currently just sufficient to face winter months, so a negative surprise next week would mean rationing, and a subsequent intensification of the ongoing slowdown. In our view, markets are already discounting decent chances of such scenario materializing. European CDS are close to wides, well in line with recessionary levels and having underperformed US notably over the past few weeks. Chemicals and materials have recently underperformed both in equity and credit. European gas futures have almost doubled over the past month, and are quickly approaching levels just seen right after the Ukraine invasion. A shutdown remains the key risk for European markets, but valuations are factoring good chances for the event, paving the way for some relief on a more positive outcome.

Currency markets – The comeback of king dollar
The past weeks saw a massive rally of the US dollar, now close to 20y highs. EUR/USD is flirting with parity, and the Dollar index is now 20% higher than in January 2021, and just 10% shy of the highs reached in early 2000s. Part of the performance is driven by monetary policy divergence, as the Fed will hike rates much faster than the ECB. The difference between 2y USD and EUR swaps is now close to 2%, vs just 0.5% one year ago. Still, the Dollar is appreciating strongly in real terms too, pointing strong market fears on European gas. Current DXY levels are likely to be supported only if the recent gas-induced deterioration of the German trade balance proves persistent. In a normalization scenario, however, the relative current account speaks in favour of Europe, so that below parity levels of EUR/USD can hardly be sustained. Risk off mood is also helping, as highlighted by fund flows that show a run to the dollar and a recent rebalance from European and EM assets towards the US. Emerging market currencies have started suffering this week on the dollar move, after having held well this year vs a sharp selloff in credit. Overall, we recognize that momentum may continue for stronger USD a bit longer, and parity may even quickly be broken. As that happens, we would look to take the other side, as valuations and positioning suggests room for a EUR comeback over the next six months, and a positive asymmetry to gas news given all the negativity in the price.

Central banks – Summer blues
July will be an important month for central banks, with the ECB meeting on July 21st, and the Fed on July 26th. Both central banks have laid out the path for 2022 hikes clearly in June, so markets will focus on communication regarding 2023. The Fed will likely hike 75bp, and the focus will be on the tone. The US curve is now pricing cuts in 2023, as markets turned worried about inflation. The first cut is priced as early as in 1Q23. We think the market could be surprised by a more hawkish tone. The job report last week confirms US labour markets are strong, and the June inflation print next week should not show abating signs. Earnings and consumer has shown some signs of weakening, but remain in expansionary territory, making harder for the Fed to justify a dovish turn at high single digit inflation levels. Any dovish turn is likely postponed to September, when supply side inflation will have dropped more meaningfully. The ECB will hike 25bp and guide to higher steps in September. The curve is pricing hikes for the next two years, but the timing by which the 2% terminal rate is reached has recently been shifted out by markets amid recession fears. A weak Euro and strong inflation dynamics in June suggests the ECB will need to echo the Fed and maintain an inflation-fighting attitude, postponing any dovishness to later this year. Communication around the anti-fragmentation tool is unlikely to provide further details.

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Algebris Investments’ Global Credit Team