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Thursday, June 24, 2021
Euro 50 - UK 100 - Consequences of a Hawkish Tilt
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*This performance is only observed with historical backtests and not traded by the company
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The yield curve started to flatten in the second quarter of 2014 which resulted in the outperformance of Tech sector, along defensive stocks such as Utilities and Healthcare. Sectors such as financials, energy and industrials performed poorly. Along with US treasury spreads narrowing, the Germany Bund spreads (benchmark for European Yields) also narrowed along the same period.
A Multi-Month Trend
The latest economic forecasts released by the Fed in the FOMC meeting for the month of June 2021, 11 of 18 policymakers expected at least two interest rate hikes by the end of 2023. The prospect of those earlier-than-expected moves have soared short-term yields higher while keeping longer-duration yields subdued as market fears of out-of-control inflation subside.
Presently, the economy is expected to witness a similar wave like it did in 2014 and thus the tech dominated indices in the EU zone should fundamentally outperform the indices that are dominated by the financial sector. This could be a gradual and a multi-month trend.
2014 onwards, as the yield curve started to tumble, the Euro 50 Index rallied and outperformed UK 100. The ratio between the two indices increased from 0.4535 to 0.5471, by approximately 21%.
The Pair Trading Strategy involves going long on Euro 50 increasing in value and simultaneously holding a short position on UK 100.
Along with the generic outlook of the Technology and IT sector rallying, the core reason for Euro 50 to surge is mainly because the major constituents of the Euro50 index are from the Consumer Discretionary sector followed by Technology and the index also comprises of blue-chip European companies from dierent sectors. The consumer discretionary sector that has a weightage of 28% in Euro 50 is anticipated to perform well with reopening of the European economy.
The UK 100 index comprises mainly of the Material and Financial sector accounting for 35 percent of the index. The banking sector will logically witness reduced net interest margins due to narrowing yield spreads in a flattening yield curve scenario. Additionally, the Energy, Material and Industrial sector may foresee lower profit margins since a cap on inflation implies a cap on sales price.
Euro 50 Sector Constituents
|Sector||€ Market Cap (In Bln)||Market Cap %|
Date: 23rd June 2021
UK 100 Sector Constituents
|Sector||€ Market Cap (In Bln)||Market Cap %|
Date: 23rd June 2021
Given the flattening of the yield curve and current sector weightings, Euro 50 index is likely to outperform UK 100.
However, it is important to note that Trading pairs is not a risk-free strategy. The jeopardy comes when prices of the two securities move contrary to the positions taken resulting in losses. Thus, it is important to adhere to strict risk management rules when dealing with such adverse situations.
Disclaimer: Individual stocks in the index are subject to both weightage recalculation & recomposition risk. As a result, certain stocks may be added or removed from the index upon index recalculation. Consequently, the performance of the relative index may deviate from the one specified above.
Note: Trading Timings (subject to change) –
Euro 50: 00:00-00:15/00:30-01:00/02:00-04:00/04:15-00:00
UK 100: 00:00-00:15/00:30-01:00/02:00-00:00
Risks and Assumptions for Back-tested trading strategies
Data Source: Bloomberg
Arun Leslie John
Chief Market Analyst
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