A tale of two currencies

Issuers are printing long euros and short dollars – a theme that seems unlikely to change, with yields remaining at rock-bottom levels in the eurozone and interest rates set to rise in the US in the second half of the year. But will this simple story change if quantitative easing works – and what will happen to holders of very long dated euro bonds if inflation and growth surge back in the eurozone, forcing yields across the region to spike?

What a difference a year makes. As 2014 ticked in, the world was a very different place. Vladimir Putin’s claws weren’t yet scratching a channel down the Donets Basin; Brent crude was still trading around the US$100 per barrel mark; and the black flags of Islamic State had yet to wave over the uplands of Syria and Iraq.

Perhaps most shockingly, Europe, racked by debt and the failed tenets of austerity, was seemingly on the verge of pulling itself back from the abyss. Industrial data in core eurozone states looked solid; Ireland had just exited its IMF bailout. Even Spain’s once toxic economy was on the mend.

Europe’s moment in the sun did not go unnoticed. Sovereigns, supranationals and agencies rushed to benefit from a euro-US dollar basis swap that spent the first half of the year trending steadily towards zero. A few institutions timed their run perfectly. Kommunalbanken Norway hit the market with its inaugural euro benchmark sale on April 1, a €1bn (US$1.13bn) five-year Reg S bond due April 2019 with a coupon of 0.875%. A euro funding programme would continue for “years to come”, the Oslo-based local government said, noting the benefit of diversifying its investor base against a “strong market backdrop”.

Back then, such talk did not seem unreasonable, or deceptively expectant. Philip Brown, head of public sector origination at Citigroup, noted the “perfect timing” of the KBN deal, and said that the cost of funding in euros in the second quarter of 2014 was “equal if not better than they could have achieved at that time in dollars”. Raw data bear this out. Euro-denominated issuance by all SSAs hit US$297bn in the first half of 2014, the best half-yearly number since the financial crisis, according to Thomson Reuters data. By contrast, the volume of US dollar prints by all SSAs slid to US$260bn, the third straight year of comparative decline.

That all changed following yet another summer of eurozone discontent. Gloomy economic data out of France and Germany revived concerns of a triple-dip recession, with deflation starting to take hold across the region. Second-half euro prints by SSAs slipped below US$100bn for the first time in five years, down 11% quarter-on-quarter and 48% year-on-year. US dollar issuance came in at US$182.2bn over the same period. Slowly, the basis swap widened, and continued to gap wider after the end of 2014, trending towards negative 30bp as January rolled to an end.

A few clear themes began to emerge in the first weeks of 2015, traditionally the busiest time of the year for capital-hungry SSAs. The first was the emergence of a bifurcation between the two currencies, with issuers tending to favour longer-dated euro prints and shorter-dated dollars.

Higher US yields, based on long-standing expectations that the Federal Reserve will hike rates in the second half, have dampened demand for longer dollar maturities. In contrast, given expectations that eurozone rates will stay low for far longer, “demand for euro-denominated assets has been for longer maturities of seven years-plus”, said Morven Jones, head of DCM, EMEA, at Nomura.

Zeina Bignier, head of public sector at Societe Generale, said: “Investors are buying short dollars due to the expectation of rising US interest rates. In contrast, eurozone interest rates are close to zero or negative, and some central banks can’t buy at that point in the curve. It’s a win-win solution in terms of borrowing in dollars then swapping back to euros, even for European sovereigns.”

This isn’t quite yet a rule of thumb for investors or SSA issuers. Demand for long dollars is still there. Rentenbank completed the first public-sector trade of 2015, the Triple A rated German agency printing a 10-year US dollar global benchmark. That was followed in short order by 10-year dollar sales from the Asian Development Bank and the Inter-American Development Bank.

The trio of January deals “illustrated that the grab for yield is not only a feature of the euro market”, said Citi’s Brown. He also pointed to a measured but discernible transformation in the make-up of the SSA investor base. Ten-year US dollar demand was increasingly “being driven by bank treasuries, who have historically stayed with shorter-dated paper, but who now need the LCR Level 1-eligible SSA assets and want the asset swap yield offered by the longer maturities.”

Euro prints are not being entirely abandoned. SSAs “are not opportunistic issuers”, said Philippe Rakotovao, global head of Credit Agricole’s corporate and investor client division.

“They have long-standing investors so they tend to issue the same way every year. They have a euro or US dollar issuance programme, plus or minus a few percentage points, they stick to it.”

But they are flexible, and will always want to hedge their bets, explaining the gradual skew towards US dollar issuance, particular in terms of shorter debt tenors.

In contrast, euro investors are going long. Some of the largest euro-denominated sales in the first weeks of 2015 by SSAs involved debt with tenors stretching into decades rather than years. January’s standout prints included Spain’s sale of €9bn worth of 10-year bonds on orders of €22.8bn, sold at 92bp over mid-swaps. The country’s second-largest syndicated placement, two-thirds bought by foreign institutional investors, also secured a coupon of just 1.6%.

“If you want euros, it’s going to remain cheaper to issue a three-year dollar sale, then swap it back again. That’s an important driver for all issuers”

Portugal meanwhile surprised markets by launching a dual-tranche bond comprising €5.5bn worth of 10-year and 30-year bonds, on orders of €14bn. Ireland followed in early February, selling €4bn worth of 30-year bonds in its first ultra-long sovereign debt sale. The eurozone was also given a boost on January 22, when the European Central Bank finally unveiled a €1.14trn QE programme that will see it buy €60bn worth of euro-denominated investment-grade securities issued by eurozone governments and agencies in the secondary market each month, from March 2015.

Yet there seems little doubt that increased demand for shorter dollar-denominated prints is here to stay, in large part due to major moves in the cross-currency basis swap between the greenback and the euro.

“If you want euros,” said one leading European agency, “it’s going to remain cheaper to issue a three-year dollar sale, then swap it back again. That’s an important driver for all issuers.”

Said Lee Cumbes, head of SSAR origination, EMEA, at Barclays: “The [QE] announcement from the ECB suggests that they will buy a lot of SSA paper denominated in euros. Despite that, the current level in the basis swap markets means it is still very attractive for issuers to sell debt in dollars instead and then swap into euros.”

Rising volatility, stemming from a host of issues from Russia’s woes to a slowing China, is widening the basis swap further, making dollars “even more attractive for issuers to fund in”, said Jamie Stirling, head of SSA origination at BNP Paribas. He points to recent debt sales from the likes of the World Bank and German state-owned development bank KfW. The latter sold US$5bn worth of 10-year bonds in November 2014 at 10bp over mid-swaps, in an area of the market that was traditionally “difficult to access”, lacking both depth and demand, Stirling said.

A host of other question marks lie over the European single currency, from the perennial (whether Greece will finally and ungraciously bow out of the eurozone) to the systemic (what level of contagion a “Grexit” would foster). But SSA issuers and investors can add another imponderable to that list: what to do about yields that regularly scrape to record lows, and even dip into negative territory.

Asian central banks have in recent years become major buyers of euro-denominated sovereign debt securities. But, said BNP Paribas’ Stirling, it was “unclear if they will continue” to buy eurozone debt if yields remain at record lows and, in some cases, in negative territory.

Central bank chiefs in emerging markets from Latin America to South-East Asia to the Middle East once saw eurozone debt as a way to wean themselves off their dollar dependence. Yet that argument, said SG’s Bignier, “is no longer relevant, so you’re likely to see demand progressively shift to higher-yielding US dollar or sterling-denominated debt”. Many tip the renminbi to emerge as an added, if still marginal, source of funding.

This time a year ago, eurozone leaders were enjoying a rare moment of calm. Brussels and Berlin were basking in the reflected glow of a stronger currency – one, moreover, in which SSAs really wanted to issue – while hoping that a fragile recovery would stick. It didn’t, of course, so here we find ourselves, struggling to contain a rambunctious new leftist government in Athens while the ECB launches the biggest co-ordinated debt buying programme in the eurozone’s short but turbulent history. What a difference a year makes.