Monthly Cash Review – EUR EUR Liquidity LVNAV Fund, December 2022

The focus in December was the European Central Bank (ECB) meeting, where the deposit rate was increased by 50bps to 2.0%, in line with market expectations. However, the tone of the bank’s messaging changed, becoming more hawkish. On the economic front, new ECB forecasts project headline and core inflation to fall from 6.3% and 4.2% in 2023 to 2.3% and 2.4% in 2025, respectively, which is still above the 2% target level. Risks remain to the upside, particularly from faster wage growth and fiscal policy. The labour market remains tight and, despite an impending recession, business surveys point to continued increases in employment. Therefore, the ECB has signalled for more rate hikes with President Christine Lagarde stating that “keeping interest rates at restrictive levels will over time reduce inflation”. At the December press conference, Lagarde pointed to at least two more 50bps rate hikes, with the potential for further rate increases beyond the first quarter of 2023. However, she also repeated that decisions will be data-dependent and taken on meeting-by meeting basis.

The ECB forecast negative growth for both Q4 2022 and Q1 2023 and a peak-to-trough contraction of 0.3%. GDP growth has been downgraded to 0.5% in 2023, down from 0.9%, but there is a more positive view for 2024 (1.9%) and 2025 (1.8%). The most recent economic data have shown signs of improvement. Inflation has eased to 10.1% on lower wholesale energy prices and a decline in oil prices. This the first decline in inflation since the energy crisis started but the rate remains significantly above target. Third quarter GDP was revised up from 0.2% to 0.3%, mainly due to resilience in household consumption. The composite purchasing managers’ index (PMI) for December improved from 47.8 to 48.8, a stronger increase than consensus expectations of 47.9. This suggests that the economy may be contracting at a slower pace, with improvements seen in manufacturing output and services. Sentiment in Germany among businesses and households has improved recently — the Ifo Business Climate Index and the ZEW Index have risen for three consecutive months. The German composite PMI saw a strong improvement from 46.3 to 48.9. These are reflective of the fading risk of gas rationing, the drop in the natural gas price from last summer’s peak, and the government finalising plans to cap electricity and gas prices for both households and businesses in the new year.

Among signs of improvement in economic data, the most important aspect remains inflation, which while declining remains high and is forecast to be above targets beyond the ECB’s projected time horizon. The ECB has signalled that there will be more rate hikes to tackle inflation, prompting the market to increase its interest rate expectations. There was little change for the next ECB meeting on 2 February 2023, with an implied rate of 2.4%. However, rate expectations were increased for later meetings (Figure 1). At the start of December, the implied rating for the May meeting was 2.7% and this rose to close the month at 3.2%. The implied peak rate pre-ECB meeting was 2.75%, but this has now increased to 3.5% for the July meeting.

European government bonds yields moved higher in line with a more hawkish ECB, as investors increased their expectations for the bank’s terminal rate. German 10-year Bund yields, and Italian 10-year government yields recorded some of their largest one-day rises in the past decade, closing the month at 2.57% (+64bps) and 4.70% (+64bps), respectively. Excess liquidity deposited with the ECB averaged €4.319 trillion in December, a small decline due to TLTRO (targeted longer-term refinancing operations) repayments. Excess liquidity is expected to reduce in early 2023 as the largest banks look to repay their loans. The euro short-term rate was stable averaging 1.40% pre-ECB rate hike and 1.90% after. Euro cash overnight deposit rates ranged between 1.35% - 1.43% pre-ECB hike, thereafter ranging from 1.85% - 1.93%. Rates moved lower for the year end, trading as low as 1.50%. Core Government repo averaged around 1.20% pre-ECB hike and post-hike around 1.70%, quickly falling to around 1.50% in the lead-up to year-end and into negative territory at year-end, between -1% and -1.7%. Euro bills remain strongly supported, expensive to other money market instruments, with maturities into January trading at a high premium. French three-month yields averaged 1.63% in December, compared to 1.37% in November.


At the fund level, the weighted average maturity (WAM) averaged 25 days in December and the weighted average life (WAL) averaged 46 days. New issuance into January was scarce and levels expensive. The focus is on high-quality credit issuers, selectively trading into the first quarter, with consideration of higher interest rates in the eurozone and year-end liquidity buffers. The allocation to government and supranational holdings was increased to provide credit quality and liquidity with year-end approaching. Some issuers were well funded and chose not to roll maturing trades. Asset-backed paper continued to be in good supply, offering flexible duration and attractive returns. Liquidity and capital preservation remained the key drivers for the portfolio, with yield a distant third.

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