Global Daily – European insurers could drive fixed income markets

by: Fouad Mehadi , Aline Schuiling

Euro Rates: European insurers could drive fixed income markets – The European insurance sector has the potential to be a strong force behind the fixed income and EUR swaps market. In a note published yesterday (see here) we took a closer look at the impact of three interest rate scenarios on the Solvency II ratios of the total European insurance sector. We have identified the four main rebalancing parameters that could be used to steer the Solvency Ratio, which are the duration of the government bond and credit portfolio, the credit quality of the credit portfolio, the EUR swap overlay and the overall hedge ratio. We then look at how their hedging and rebalancing behaviour would impact the EUR rates market.

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In our base case scenario for Euro rates not much rebalancing is expected in the coming year. However, mind the paying flows in EUR swaps that should accompany the rise in rates due to more volatility. We expect paying flows across the EUR swaps curve, with the majority of the paying concentrated in the 10y to 25y part of the curve.

In the second scenario of higher interest rates, we assume that interest rates will rise to levels seen before QE was announced. We find that with aggressively higher rates the Solvency Ratio gets hit hard. The rebalancing requires duration shortening in the government and credit portfolio, improvement in credit quality via covered bonds and paying in EUR swaps. A decrease in the interest rate hedge ratio from 80% to 75% is also needed. Therefore, the rebalancing in swaps would require a significant amount of paying in the 15y and 20y area.

Finally, we find that in the third scenario of lower interest rates – characterised by heightened political risk in Europe – stabilizing the Solvency Ratio will mainly be achieved by extending the duration of the government bond portfolio and a higher hedge ratio overall. But insurers would try to avoid the ‘poverty trap’. Therefore, the credit portfolio remains crucial for return. The increase in the hedge ratio will result in paying flows up to 10y and receiving flows longer up the EUR swaps curve. (Fouad Mehadi)

Euro macro: Unemployment declines, but still a lot of slack in the labour market – The eurozone unemployment rate has been declining non-stop during the past 4.5 years. It fell to 8.8% in October, down from 8.9% in November. It has now reached its lowest level since early 2009, but is still significantly higher than at the end of 2007 (before the global crisis), when it was just above 7%. Moreover, there is still a lot of additional slack in the labour market. Indeed, the unemployment rate only measures part of the overall slack in the labour market. A broader measure, the U6-indicator, has recently received a lot of attention in the US and Europe. This definition includes the people that are unemployed, but do not fit into the standard definition of the unemployment rate. More specifically, they are unemployed and immediately available to start working but are not actively seeking a job, or they are unemployed and actively seeking a job but are not immediately available to start working. On top of that, the U6-indicator includes people that are working part-time, but would like to work more hours.

This U-6 indicator of labour market slack stood at 18% in 2017Q2, well above the level at the end of 2007 of 15%. Considering this broader definition of labour market slack, we think that employment in the eurozone will need to grow robustly during a considerable period before the labour market will start to tighten. Indeed, we expect labour market slack on aggregate not to be exhausted before around the end of 2019. A sharp acceleration in eurozone wage growth is therefore unlikely before then. However, there might be some upward wage pressure next year, as higher headline inflation feeds through into higher pay settlements. For more on eurozone labour market slack and the situation in individual countries, please see here. (Aline Schuiling)