Monthly Cash Review – EUR State Street EUR Liquidity LVNAV Fund, February 2023
In line with expectations, the European Central Bank (ECB) increased rates by 50 basis points (bps) at its 2 February meeting to bring the deposit rate to 2.5%. In the post-decision statement, it was stated, "In view of the underlying inflation pressures, the Governing Council intends to raise interest rates by another 50 basis points at its next monetary policy meeting in March and it will then evaluate the subsequent path of its monetary policy." The ECB also shifted their inflation guidance to suggest inflation risks are now more balanced. The main driver behind this was the fall in energy prices but it also considered wage developments, fiscal policy, and the reopening of China. Market focus for the remainder of the month was on economic data as there was little formal guidance after the March meeting.
The main surprise was that January’s headline inflation rate was revised up from 8.5% to 8.6%, following the late release of Germany’s data. The core inflation rate (which excludes energy and food) was also revised up from 5.2% to 5.3%. New weights were applied for the harmonised index of consumer prices (HICP) basket; if changes had not been made the inflation rate would have been higher. Both energy and food inflation are expected to continue to fall. Services inflation was unchanged at 4.4%, while core goods inflation rose again to 6.7%. At the end of the month, preliminary inflation data in France and Spain for February were higher on a year-on-year basis, although the month-on-month numbers were in line with expectations. The second estimate of Q4 2022 GDP was unchanged at 0.1%, down from 0.3% in Q3; this is consistent with a slowdown in growth but still better than earlier expectations of a negative print. The composite purchasing managers’ index (PMI) printed at 52.3 in February versus 50.3 in January and the consensus forecast of 50.7, and is suggestive of economic growth in Q1 2023. This was driven entirely by the services PMI, which rose to 53.0 from 50.8 in January amid rising services demand, easing supply pressures, and filling of past manufacturing orders. PMI readings in excess of 50 are indicative of growing activity. The labour market remains tight with the unemployment rate stable at 6.6%, while surveys point to continued growth in employment. The money and credit data confirmed the impact of inflation and higher rates, with both households and businesses placing money in longer-term deposits and lending growth has slowed sharply. Consumer indicators reveal that household spending fell in Q4 2022 and, with further interest rate increases to come, there will likely be further weakness in the credit data.
Markets
Forecast are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate.
The current hawkish ECB tone has been driven by the high current inflation. While the headline rate has passed its peak, core inflation remains high. Recent inflation prints have meant that markets began raising future rate expectations. During the month, ECB President Christine Lagarde repeated that the ECB intends to raise the policy rate by 50bps at the March meeting, but that what comes after the March meeting will be data dependent. Economic activity has been resilient with the PMI readings reflecting growth on the back of services and better-than-expected GDP. However, the labour market remains tight even as wage growth in H2 2022 was relatively subdued. With price pressures in the services sector continuing to be significant, the overall picture suggests that core inflation likely remains above 2%. Market implied rates for the meeting in March have remained stable and have risen to 3.28% for the meeting in May. Hopes of ECB interest rate cuts in 2023 have dissipated, with expectations of a peak in eurozone rates being pushed into 2024, reaching 4% by February.
European government bond yields reversed January’s move in response to expectations of higher rates into 2024 along with stubbornly high European inflation. German 10-year Bund yields closed the month at 2.65% (37 bps higher over the month). Italian 10-year government yields followed suit, closing the month at 4.47% (18 bps higher in February). Excess liquidity deposited with the ECB averaged €4.134 trillion in February, slightly higher than January’s average. Excess liquidity should continue to reduce in early 2023 as the largest banks look to repay their TLTRO (targeted longer-term refinancing operations) loans as regulatory considerations kick in. The next TLTRO repayment is scheduled for 29 March. The euro short-term rate (€STR) ranged 1.90%-2.41% in February, averaging 2.27% with the ECB’s rate hike coming into effect on 8 February. Euribor rates continued to move higher across the curve, with further hikes being considered for March and into the second quarter of 2023; one-month Euribor averaged 2.37%; three-month Euribor averaged 2.64%; six-month Euribor averaged 3.14%; and one-year Euribor averaged 3.53%.
Fund
At the fund level, the weighted average maturity (WAM) averaged 15 days in February and the weighted average life (WAL) averaged 41 days. The focus is on high-quality credit issuers in the one-to-three months range, with consideration of further interest rate hikes. Investments were maintained in bank floating money market securities, linked to the €STR overnight index, offering attractive spreads and diversification. Holdings in sovereign, agency, and government-guaranteed securities were increased to provide high credit quality and maintain liquidity buffers. Asset-backed paper continued to be in good supply, offering flexible duration and attractive returns compared to vanilla paper. As always, liquidity and capital preservation remained the key drivers for the portfolio, with yield a distant third.