JP Morgan: Summer storm in the bond market – underweight in the periphery, what does he see for Greece

By Eleftherias Kourtalis

The global economy is at a critical juncture and there is a risk of a recession in the second half of 2022 due to inflationary headwinds and tightening economic conditions, with a 40% chance, JP Morgan notes in its new report on bond market outlook.

Should strong fundamentals and strong balance sheets allow the economy to withstand the risk of a recession in the very near term, there is still a risk of a recession in mid-to-late 2023 due to continued tightening by central banks.

So if a recession is avoided this year (60% probability) there will be – conditionally – a 30% chance of a recession by the end of next year. JP Morgan’s baseline scenario, however, remains that recession will be avoided in 2022 and 2023, with a soft landing for the global economy, on the belief that the strength of the current economic expansion is capable of withstanding headwinds from inflation and from monetary policy tightening

Regarding the eurozone bond market, JP Morgan maintains a broadly bullish outlook for the second half of 2022, but this is based on an eventual delivery of a credible anti-fragmentation tool by the ECB. On the anti-fragmentation tool, the ECB’s recent commentary after the ad-hoc meeting in mid-June suggests that there is still a wide divergence of views across the board that would require tough negotiations to reach a compromise on some critical details.

With this data, the US bank chooses to maintain short-term underweight positions on all euro zone bonds as it believes that the market will continue to test the ECB until it announces details of the anti-fragmentation tool.

The main risks to its underweight stance come from the ECB’s willingness to aggressively use PEPP’s flexible reinvestments, which have been activated since 1 July. It is not yet clear how reinvestment flexibility would work in practice, and this lack of clarity, in her view, reduces the effectiveness of the tool itself, given that, in times of stressed market conditions, market participants would have information on flexibility of PEPP reinvestments from unofficial figures only.

The recent flow of news from ECB sources on PEPP reinvestments suggests that the ECB may be willing to shift the monthly purchase towards peripheral markets, but it is unclear whether there is a willingness for front-end reinvestments. With PEPP and APP bond maturities falling sharply after the summer and due to reduced ECB monthly flows (€45bn in H2 2022 vs €85bn in H1 2022), JP Morgan believes that PEPP’s flexible reinvestments may have limited power, especially during a period of market stress, unless the ECB decides to move forward (ie reinvest funds from bonds maturing in the future).

Thus, JP Morgan recommends long positions in German 5-year bonds versus US bonds, underweight positions in the periphery via short Italian 10-year bonds versus German 10-year bonds and long positions in Belgian 30-year bonds versus French bonds, long Austrian 10-year bonds versus French bonds as well , and short positions in 15-year Portuguese versus Spanish bonds.

Regarding Greece in particular, JP Morgan does not recommend any short trade, and notes that yesterday’s auction through the reopening of the bond maturing in 2032 increases the liquidity of this security and estimates that the specific bonds are quite attractive for investors.

More generally, he expects a continuous de-escalation of Greek spreads during the rest of the year as well as in 2023. Thus he expects them to be at 210 bp. in September from about 235 m.v. today, at 200 m.v. in December 2022 and March 2023, and at 170 m.v. in June 2023.

Regarding the Greek economy, JP Morgan expects growth of 3.5% this year in Greece with inflation at 6.3%. Greek debt is expected to decrease this year to 186% of GDP, and the budget deficit to 4.3% of GDP, with the primary balance deficit moving to 1.9%.