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As Good As It Gets? - High Quality Credit Spreads

FICC Podcasts 15 septembre 2021
FICC Podcasts 15 septembre 2021


Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the recent onslaught in high grade corporate supply and what to expect for issuance the rest of September. They then discuss looming technical changes facing high grade credit markets including the impact of the debt ceiling resolution, Fed tapering, and possible Treasury coupon auction cuts on reserve balances and credit spreads.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Disponible en anglais seulement

Dan Krieter:

Hello, and welcome to Macro Horizon's High Quality Spreads for the week of September 15th, As Good As It Gets. I'm your host, Dan creator here with Dan Belton, as we discuss the onslaught of high grade corporate supply thus far in September, and look ahead to the impact of technical conditions through the balance of this year and beyond.

Dan Krieter:

Each week, we offer our view credit spreads, ranging from the highest quality sectors, such as agencies in SSA's to investment grade corporates. We also focus on us dollar swap spreads and all the factors that entails including funding markets, cross currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at Dan.krieter@bmo.com. We value and greatly appreciate your input.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Dan Krieter:

Well, Dan it's been two weeks since our last podcast, there was a monthly round table episode last week, and certainly the story of the past two weeks has been supply. Why don't you start off by giving us the high level numbers and how this September's fitting in compared to years past.

Dan Belton:

Sure, Dan. So in the six sessions we've had since Labor Day, we've had about 110 billion in supply. Now that's in line with what we saw in each of the last two years for the first two weeks after Labor Day. So very heavy as we were expecting, and probably going to be a front loaded month. So the first week after Labor Day, we saw 81 billion price, 57 deals. So remarkably heavy first week, and then supply has really continued to be strong. We had 20 billion on Monday, followed by 9 billion on Tuesday. And by and large, these deals have gone very well. We've had negative new issue concessions, both of the last two weeks order book coverage in the high twos, or even as high as three times covered. And it doesn't seem like there's any obvious limit to this demand right now.

Dan Krieter:

Yeah, I certainly think that's the main story we were expecting very heavy supply, everybody was, it has come. The main story for me is how well spreads have performed. And in particular with equity sort of wobbling here over the past week and a half, you have risk sentiment a little bit lower and obviously massive supply. And as you said, reception has gone well. And I think it's important to note that primary market demand metrics have actually improved as supply has worn on. I think the highest day of concessions in September was that first Tuesday following Labor Day, when obviously we had big supply, issuers weren't exactly sure on market conditions, maybe attached a bit more concession to stand out with a lot of competing supply, but even as issuance has stayed heavy, we've seen those concessions come down. We've seen really very little evidence of fatigue in high grade Corpus for the most part.

Dan Krieter:

So that fits in with what we were talking about coming into the month. We were expecting very heavy supply, but that we thought spreads could actually narrow through that supply. Now we're in the teeth of the supply right now, as you said, Dan, September supply is always very front loaded. That's even more true this year with an FOMC meeting that market participants reviewing is a rather important meeting. So supply should likely be constrained next week, and then we get into October. So it's not a huge surprise to see spreads just trading sideways for the month of September thus far. And I actually think it's a pretty bullish sign for what we might expect to see as issuance begins to slow.

Dan Belton:

Yeah, Dan, I think we will see issuance start to slow beginning next week. So typically when the FOMC meeting falls in this third week after Labor Day, like it does this year, we get about 70% of September supply just in these first two weeks. So if we end up this week with something in the realm of 120, 130 billion in issuance, we're probably only due for another 50 billion or so in the rest of September. So I think at that point we could start to see spreads really outperform, given just that the focus among credit investors these past two weeks has been on primary markets and not secondary market activity by and large.

Dan Krieter:

Yeah. And it's when we get that renewed focus on secondary market activity where we expect spreads to begin to perform again. Because we'll get some of this technical pressure taken away and then looking at things from a fundamental perspective, obviously things haven't changed, fundamentals still very strong in the corporate space. We're seeing the return of share buybacks and distribution to shareholders in force, really back to pre-pandemic levels now, just again, reiterating this of corporate balance sheets here, and then obviously the big one being the macroeconomic environment. I think we got some clarity with that just yesterday. When we got the CPI print that actually came in lower than economists expectations that were already building expectations for a slowing of the heavy inflation we've seen for these past few months. And we've been pretty consistent in our view that inflation actually represented the biggest threat to credit spreads in the near term. Not saying that we expected inflation to be very, very high, but all the factors other than inflation were supportive of credit spreads continuing to narrow.

Dan Belton:

That's right. And yesterday's print really stands out as a victory for those in the inflation is transitory camp. When you look up and down the details of that print, it's really clear that a lot of the factors that have been driving the high inflation in recent months, we're actually starting to reverse and really dragging on this number. And that's something that we had expected for a lot of the past few months, which was that as these used car prices and prices of travel and things that were subject to the supply bottlenecks started to reverse, as we ultimately knew they would, that would actually start to drag on inflation. I think that's exactly what we saw. So what's interesting to me, Dan, is that after yesterday's print, we saw the market start to price out some removal of Fed accommodation, but it still wasn't enough to turn risk sentiment positive. And we've had equities move lower five of the past six sessions.

Dan Krieter:

Yeah. The headlines were certainly that the lower inflation print may give the Fed cover to maybe delay the removal of monetary policy accommodation. For me, that doesn't really matter. I don't think tapering matters much. It's coming at the end of the year. We all know it. And I really just don't think that's going to be a key mover of the market. For me, the main takeaway from the CPI print is that we may not have this quote unquote bad inflation. The supply side inflation that would really potentially hurt corporate bottom lines. If you have the cost of inputs going up while struggling to pass along those higher input prices to a consumer, then you've got some net profit margins going down and perhaps renewed fears on downgrade. That's not going to happen now, it appears, with inflation moving lower as you just talked about out. So for me, that's the important takeaway from inflation.

Dan Krieter:

I think the Fed is doing what the Fed's going to do. We know that the timeline for tapering is divorced from rate hikes. So I'm sort of agnostic to the Feds tapering timeline at this point. And with inflation now sort of more under control, we can look at other macroeconomic variables and here I want to talk a bit about the divergence between inflation break evens and real yields. We know inflation breakeven have remained elevated and we've seen real yields fall to historically low levels or negative 1% in the tenure. And if we consider real yields sort of the proxy for what we expect economic growth to be, clearly the rates market here telling us that we're not expecting robust economic growth. And we're certainly on board with that, it's the consensus view, but likely the right one. That makes sense in a variant environment that we're going to be in for the foreseeable future, where there's going to be new variants, new threats, particularly with lower vaccination rates around the world.

Dan Krieter:

There's going to be a lot of uncertainty and that's going to keep treasury yields pretty well anchored. And that's an important thing because even with credit spreads now what, six basis points off the lows seen at the end of June, there's still some relative value in corporate spreads, or you can make an argument for it at least. I mean, if you look at just the ratio of say the broad IG index to 10 year treasuries, we're at a yield enhancer right now of about 64%. And that's right on top of the average, since we started seeing daily spread index data published back in 2002. And if we confine that time period to just post-crisis low rate, low volatility environment, that's likely going to be very similar to what we're heading into, that yield enhancement average is about 55%.

Dan Krieter:

So if you look at it from that perspective, you can see some relative value in spread products here, even on an absolute basis at very, very low levels. And given the prevailing view for the next few months, that inflation is now under control, treasury rates are still very low, we're not really expecting them to go up. That's all the ingredients we need for a yield grab environment where these relative value metrics start to propel credit spreads narrower.

Dan Belton:

Hey, Dan, I think you laid out really the crux of our argument for why we prefer moving down in credit, at least in the near term into year end. We have supply really starting to settle down. Technicals are going to turn more favorable. And the macroeconomic environment really looks positive at this point. We have upgrades, outpacing downgrades, significantly corporate fundamentals are very strong and the risk posed by inflation is much smaller than it felt maybe before yesterday's CPI print.

Dan Krieter:

And then you have that cherry on top, or potential cherry on top of maybe stimulus, at least on the fiscal side, isn't removed as quickly as we're currently projecting. I mean, we have seen the extension of certain programs. Others have been allowed to expire. I think that they're certainly going to be coming off now in the months ahead, but we also have that 3.5 trillion spending bill that the Democrats are working on that I don't think we've had enough clarity yet for that to really be fully priced. That's going to be potentially another fiscal tailwind for credit going forward as really politics is going to take center stage now probably for the next couple months with debt ceiling negotiations. They're very likely to be wrapped up in this $3.5 trillion bill.

Dan Krieter:

We're already seeing Democrats start to give away a little bit coming off some of the tax increases that they were calling for and an effort to push this bill through. So I think that's going to be one of the key stories going forward, but it sounds to me, Dan, like we're in lockstep here with our view that credit spread sort of the runway is clear to continue narrowing here and likely threaten the historical lows of 75 basis points, the lowest levels ever observed on the IG index. I really think we could be threatening those levels come October. But looking past October really for the first time, I think you can maybe start to see the potential for technicals turning a little less supportive.

Dan Belton:

So I want to highlight a couple factors that I think are going to pose a longer term headwind for credit spreads. So the first is the Feds tapering, which I think has been well communicated at this point that the Fed is likely on pace to announce tapering later this year and probably begin it by the beginning of next year. So Fed QE has been such a strong tailwind for credit spreads since it was enacted a year and a half ago. And I think it stands to reason that even if the market is not going to react to an announcement of tapering, the simple mechanics of increased treasury and MBS having to clear the market without the Fed support and just the reversal of how the Fed has pushed investors out the credit spectrum that could end up weighing on credit spreads.

Dan Belton:

And I think just broadly, one of the mechanical tailwinds that QE has presented for credit spreads has come in the form of increased bank reserves. And one of the byproducts of QE is that the Fed's balance sheet expanded and the level of bank reserves has grown to about 4.3 trillion. Now that is a significantly higher amount of reserves than the economy needs right now. But I think just this massive amount of liquidity in the financial system has really aided financial asset prices and credit spreads have been a beneficiary to this.

Dan Krieter:

And here you're talking about the so-called portfolio channel of QE, where the Fed floods the market with reserves and investors are increasingly pushed down the credit spectrum and out the maturity curve by the influx of reserves. And I think that has been a very, very key tailwind for all financial asset prices like you said, IG spreads being no exception. But I do want to take a moment to clarify what I said earlier. I said I was agnostic of the Fed. I just want to clarify that I meant the announcement of tapering. So I'm with you, Dan. I don't think that's going to matter much, but as you look ahead to the actual mechanics of QE and the Fed taking their foot off that reserve injection gas pedal, I think that does matter, even though we know reserves are going to stay very, very heavy, for me, it's a stock versus flow argument. And yes, the stock of reserves is going to stay high, but the flow is going to start turning around.

Dan Krieter:

And this is where the title of the episode comes from, As Good As It Gets. Is this as good as it gets for financial asset prices, at least regarding the influx of reserves into the financial system? Dan, you touched on QE. I want to bring up another very important factor, which has been the dynamics around this debt ceiling that have really sort of flown under the radar for 2021, but have been an extremely important story. Let's start with the beginning of the year, we had treasuries cash balance at what, 1.6 trillion or something like that? We're down now to about 200 billion. So that's $1.4 trillion in reserves that have been put into the, by declining treasury cash balances. I mean, to put that number in perspective, that's equivalent of over 10 months of QE, just from the Treasury's cash account to the Fed alone, that's in addition to QE.

Dan Krieter:

So it's almost been a second QE coming from treasury's cash balance. And we know that that cash balance is going to continue falling here until the debt ceiling is resolved. So the 200 billion could drop as low as what 150 billion, who knows I'm pulling numbers here, but we all know that's going to keep dropping as we approach that X date. But once that date gets here, the treasury has already indicated that they will likely quickly run their cash balance up to around 800 billion, which is what we expect to be their neutral level of cash. So looking at it from a timing perspective, seeing your mid September, obviously reserve inject is going to continue unabated here for at least the next month, probably maybe even month and a half, where we still have full QE. We have the treasury cash account continuing to drop as we get closer and closer to the X date.

Dan Krieter:

But when we get to say late October, we know that Congress is going to have to come up with some form of a debt ceiling resolution, whatever that looks like. And when they do, we're going to quickly have the influence of TGA's playing reverse and suddenly start pulling reserves out of the system to the tune of 600 billion now. And probably more than that, by the time we get here. So we're going to have a very quick reduction of about $700 billion in reserves that brings us to about year end. And that's when we expect the Fed to start declining their asset purchases and starting to shrink reserve injection from the QE channel in early next year. So I guess the question for you, Dan, is, is this as good as it gets from a credit market perspective when you think about reserve injections into the system, macroeconomic variables, things of that nature?

Dan Belton:

Yeah. So I'll throw out one more offsetting factor. And that is that we expect treasury to start cutting its coupon auction sizes as early as later this year, but probably in early 2022 at the latest. There's a lot of unknowns with respect to treasury financing needs and a lot of it has to do with the fiscal packages in Congress right now. But our base case is that the amount of treasury coupon auction cuts is going to roughly offset the Fed tapering just from the standpoint of the amount of treasuries needed to clear the market, excluding the Fed. So treasury auction cuts are not going to do anything to the reserve side of things, but from a crowding out standpoint, it's going to somewhat neutralize Fed tapering.

Dan Belton:

But I do think the wild card there in a sense is this treasury cash balance. And once that starts to increase in drain reserves from the system, I think that is going to be the factor that makes the future environment for credit spreads slightly more challenging. Now, again, I think you brought up a good point with the stock versus flow argument. There's a lot of cash out there and it's not going anywhere. We have $1.1 trillion sitting at the RRP facility. If we lose 600 billion in reserves, credit spreads are not going to blow out here. But I do think that 600 billion is a meaningful amount that is going to ultimately result in some revaluations of asset prices.

Dan Krieter:

Yeah. Your point is well taken reserves going to be very, very high, no matter what the stock of reserves is. So I'm definitely not saying here that I think the reversal of some of these trends that have been in place now for a year and a half since the pandemic arrived, I'm not saying they're going to reverse course and suddenly spreads are going to start widening materially. The point I'm trying to make is, maybe that tailwind is going to weaken. And when we're talking about spreads at near historically low levels, I think that's important. That that has been a consistent downward pressure on spreads for all of 2021 that, that might now dissipate. And maybe here it's worth sort of looking at the two issues independently. I think the TGA account itself is obviously more idiosyncratic, it's sort of a one time thing. We're going to have a quick removal of six, 700 billion from the system.

Dan Krieter:

And I think then you could actually maybe even see a little upward pressure on credits, but it's going to be fast and we'll see RRP volumes decline. And there might be some rebalancing of asset allocations here that could maybe put a little pressure on credit spreads into year end, but then that will be over. And then looking ahead to 2022 you're right, we do have an offset from treasury coupon cuts though, that is of course, highly uncertain and likely a lot will depend on what actually ends up happening with this $3.5 trillion spending plan that Democrats are trying to push across. That was supposed to be very self-funding. We were going to have higher taxes, higher capital gains taxes, things of that nature. Already they're looking at lowering that I think they were originally calling for 39% in capital gains, that's down. I think at 25%, I can't remember exactly off the top of my head, but a much smaller increase there. And the corporates tax rate going up by less than what the Democrats were originally calling for.

Dan Krieter:

So this may not be as self-funding as we originally thought it was going to be. So then we would likely have those treasury coupon cuts not be as large as maybe they would be. Again, we don't need to spend a ton of time here, it's uncertain. But I just think that there is a compelling argument to be made here that we might be sitting currently at about as good as it's going to get for credit spreads here. And so looking ahead into the end of the year, I'm certainly very bullish on credit spreads here for the next, say through late October, I think swap spreads will stay very, very low, but as we approach November, it wouldn't surprise me to see some credit spread widening alongside the debt ceiling resolution. And also we're getting into a poor liquidity time of the year where, and I'm not talking about December here, but we just tend to see lower secondary market activity investors sort of locking in their performance for the year, particularly with the way spreads have tightened this year.

Dan Krieter:

And we could just see a soft patch at the end of the year that maybe would allow for us to lighten up a little bit, take some profits and look ahead to take advantage of heavy supply then come January. And quickly from a swap spread perspective. Obviously spreads have been very, very low. That 700 billion I think is more meaningful for swap spreads than it is for credit spreads. And you could see finally, a bit of a pop in swap spreads toward the end of the year, which again, I don't think we're going to see a meaningful and sustainable widening, but you could maybe set some longs and swap spreads or go asset swap on some of your credit positions and look to take advantage of some widening and swap spreads there. And also, I guess, while we're on the topic of looking forward to 20222, we did in our written work last week, lay out our initial projection for 2022 corporate supply, sort of our first look.

Dan Krieter:

And I think there is one trend that's worth talking about it here. Obviously we've talked about how heavy corporate supply has been on a growth basis all year, but net corporate supply has actually not been that outsized. It's been about 400 billion given a lot of liability management and some de-leveraging by corporations, net corporate supply is going to finish the year, probably around a growth rate of four and a half to 5% in corporate debt outstanding, that's pretty heavy, but it's in line with what we were seeing in 2016, 2017, 2018, 2019, not the 10, 11% growth rate we saw in 2020. So looking ahead to 2022, we expect to see net corporate issue and start to go up again, which is the pattern we typically see coming out of recessions, where there's a period of balance sheet maintenance and de-leveraging right after the economic stress. And then you start to see increases in CapEx.

Dan Krieter:

You start to see more companies taking on debt to put it for productive uses, which would then influence the corporate supply projection higher. Now that is mitigated by what will likely be lower liability management issuance next year to result in sort of a neutral outlook for corporate supply. Again, probably going to finish the year in the 1.3, $1.4 million range next year I talk about that because we've highlighted throughout this podcast, how much reserves have come into the system, which has obviously made corporate supply a lot easier to be digested. We're talking about those reserves going down and then potentially not as many reserves that need to soak up still heavy corporate supply in 2022. So I guess to put a bow on the entire topic here, I'm getting to the point where I feel like we might be as good as it gets in the corporate market here in the next two months. And we'll see how tight spreads get. And from there we can maybe reevaluate what we expect to be the natural trading range for credit in 2022.

Dan Belton:

Well, I think that wraps it up just on a programming note, we'll be back next Wednesday, immediately following the F OMC meeting. Thanks for listening.

Dan Belton:

Thanks for listening to Macro Horizons, please visit us at BMO cm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible. We'd love to hear what you thought of today's episode. Please email us at Daniel.Belton@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including FICC macro strategy group in BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:

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Dan Krieter, CFA Directeur, Stratégie sur titres à revenu fixe
Dan Belton Vice-président - Stratégie sur titres à revenu fixe, Ph. D.

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