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Monthly Cash Review - EUR State Street EUR Liquidity LVNAV Fund



The Governing Council of the European Central Bank acted in response to higher-than-expected inflation, and the risk that this is more than transitory, by returning the deposit rate to neutral in July. Meanwhile, fears are growing around gas supplies from Russia as supply through the Nord Stream 1 pipeline was reduced to 20% of capacity. This resulted in increased European natural gas prices, adding to inflationary pressures along with an increased risk of rationing this winter. The ECB’s most recent forecast that inflation would average 7.3% in Q3 is already looking unrealistic and further upward revision is likely. Data shows that real incomes are falling, while business sentiment has plummeted as demand declines and costs continue to rise. On top of this, the labour market remains tight and wage pressures are picking up. The collapse of the government in Italy has added some political uncertainty to the mix, with elections due to take place on 25 September.

Policy

The ECB Governing Council contradicted its own June forward guidance for a 25 basis points (bps) increase in the deposit rate by instead hiking by 50bps; this lifted the deposit rate to 0% and the main refinancing rate to 0.5%. This bigger-than-expected move was based on the stronger inflation dynamics since June and by the approval of the Transmission Protection Instrument (TPI). Forward guidance on interest rates was removed as the Governing Council would “make a transition to a meeting-by-meeting approach to interest rate decisions”, meaning that this will be data dependent.

The TPI can be “activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.” Purchases are ex-ante unlimited in terms of size, but the size of purchases will be determined by the severity of the risks facing policy transmission. There are macro and fiscal eligibility criteria. These are cumulative, meaning all conditions need to be fulfilled and include that the country is complying with the EU fiscal framework and is not subject to an excessive deficit procedure.

Data

Eurozone GDP increased 0.7% quarter-on-quarter (q/q) in Q2, much better than consensus forecasts of 0.2%, driven primarily by the re-opening of the services sector. Growth in Italy (1%/q), France (0.5%) and Spain (1.1%) was largely due to tourism. Germany was flat, but Q1 growth was revised up to 0.8%.

The Flash HICP saw headline inflation increase from 8.6% in June to 8.9% in July, above consensus of 8.6%. Food inflation increased to a new high, but energy inflation declined from 42.0% to 39.7%. Core inflation (excluding food, energy, alcohol and tobacco) rose from 3.7% to 4.0%. Both services and non-energy goods inflation rose.

German HICP increased by 0.8% m/m and by 8.5% year-on-year. This confirms that the easing of inflation seen in June was driven by the short-term technical factors.

The composite purchasing managers’ index (PMI) fell from 52.0 to 49.4 in July, lower than consensus of 51.0. The fall below 50 is consistent with activity contracting. The services PMI declined to 50.6 and the manufacturing PMI fell to 46.1. Demand has weakened with the manufacturing new orders index dropping to 42.6. The new business component of the services sector has also now fallen below 50, and hence into contractionary territory.

The European Commission’s economic sentiment indicator (ESI) fell from a downwardly revised 103.5 in June to 99.0 in July. The decline was across all sectors, but industrial and services confidence saw the largest declines in July, primarily due to a fall in orders. Along similar lines, the German Ifo Business Climate Index (BCI) fell from a revised 92.2 in June to 88.6 in July, an outcome that was worse than consensus. The German ZEW economic sentiment fell to -53.8 in July, declining by 25.8 points in the month. This was considerably lower than the consensus expectation of -38.3 and is indicative of a recession.

The Employment index declined to 107.0 in July from 110.2 in June, but the index remains above its long-run average. A number of firms in the services sector have cited labour shortages as a constraint on production.

Outlook

The latest data suggests that inflation projections will need to be revised higher by the ECB. The forward guidance for rates has been amended and decisions going forward will now be data driven. The market is pricing in further rate increases to combat inflation, with increases expected at the remaining three meetings of this year. The question for markets centres around the size of the hikes. The market is 50/50 between a 25bps or a 50bps hike at the next meeting in September. The current expectation is that the year-end rate will be 0.75% or 1.00%.

Markets

Yields moved higher across the board following the increase in interest rates. One-month Euribor closed at -0.07%; three-month Euribor at 0.23%; six-month Euribor at 0.65% and one-year Euribor at 0.92%, although the one-year rate did fix as high as +1.20% on 22 July. The euro short-term rate was stable, averaging -0.58% to 27 July before closing the month at -0.09%. The euro cash overnight deposit rate ranged -0.59% to -0.65% until the 27 July, with a new range of -0.07 to -0.12% then seen for the remaining days of the month. Core Government repo moved from -0.65% to -0.16%. Euro government bills remained expensive. French three-month yields averaged -0.22% in July compared to -0.49% in June and closed the month at +0.01%. Following the rate increase, three-month euro bills moved to around zero.

German 10-year Bund yields fell to 0.81%, compared to the June close of 1.33%, averaging 1.14% for the month. Italian 10-year government yields closed July at 3.01%, compared to June at 3.26%, with an average for the month of 3.24%. The spread between 10-year Italian and Germany bond yields remains in focus, averaging 210bps over the month, within a range of 186-238 bps, compared to 188-242 bps in June.

Fund

At the fund level, the weighted average maturity (WAM) averaged 20 days in July. We targeted high-quality credit issuers in the one-to-two-month duration range, focusing on a shorter duration for the fund given expectations of higher interest rates in the eurozone. We maintained our allocation to sovereign, agency and government guaranteed issuers to provide credit quality and maintain our 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.


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