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Flight to Ambiguity - High Quality Credit Spreads

FICC Podcasts 07 juillet 2021
FICC Podcasts 07 juillet 2021

 

Dan Krieter and Dan Belton discuss the recent rally in Treasury yields and what it means for credit spreads. Other topics include the implications for Fed policy and forthcoming details on a potential boost for corporate paper from pension funds.


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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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Dan Krieter:                                           Hello and welcome to Macro Horizons High Quality Spreads for the week of July 7th, Flight to Ambiguity. I'm your host Dan Krieter here with Dan Belton. As we discuss this week's unique rally and treasury yields and what it means for the path of credit spreads in both the near term and the longterm. Each week, we offer a view on credit spreads, ranging from the highest quality sectors such as agencies and SSAs 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 email 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, its affiliates, or subsidiaries.

Dan Krieter:                                           Well Belton, I think there's only one place we can really start today's podcast, and that's by talking about the big rally and treasury yields we've had this week that has now brought treasuries down to just above 130 as we record and brings the peak to trough move from the March 31 peak and yields to over 40 basis points in the 10-year. Now, fortunately, we did not focus on treasury yields. If we did, I promise you I would have gotten this move quite wrong. Tip of the cap to BMO rate strategist, Ian Lyngen, who basically nailed this and has been calling for 140 or beneath on the 10-year for a while now. Fortunately for us, we focus on credit and we have maintained a neutral stance on credit for the better part of the last quarter. Despite the big move in treasuries, it looks like the neutral stance was right, at least so far.

Dan Belton:                                            Yeah, Dan. So we talked a lot in the first quarter about what a narrow range that credit spreads have been confined to. They traded an 11 basis point range in the first quarter of the year. The second quarter range was even narrower at 10 basis points, and we're really stuck towards the bottom end of that range, but it doesn't seem like there's an obvious catalyst to get us outside of that range at this point. Now, I think this recent rally and treasury yields could be that. We could see a little bit of narrowing on the back of that, just based on the relative value argument that we've made on this podcast many times before, which is that lower treasury yields effectively makes that asset class less attractive relative to credit spreads, which should bid credit spreads narrower, all else equal.

Dan Krieter:                                           We'll certainly get into that, but before we get there, I want to just take a step back and talk about how the neutral view on credit appears to be right because credit is not moving in response to this really surprising rally and treasury yields. We're maybe a basis point wider, tone feels a little bit softer, but we're still trading, as you said Dan, within a basis point or two of post-crisis lows. I use the word unique to describe the treasury rally at the top of show, and the reason I said unique is because we are seeing such a significant repressing of treasury yield without any real reaction in credit at all. Equities are essentially unchanged as well, still bouncing around near the top. So you don't often historically see such a volatile move in treasury without any reaction in credit. In fact, I went back over the past 10 years since the financial crisis to look at all the instances of 10-year yields trading 20% or more lower in the span of three months.
                                                       I found about 10 of them and of the 10 only one was not accompanied by an appreciable moving credit. That one was the 2019 environment where we saw 10-year treasury yields rally pretty significantly as the Fed embarked on its first cutting campaign since the global financial crisis. So I think you have a pretty unique set of circumstances there in 2019 that sets it apart from the other nine episodes, and all of those nine, when we saw the 20% rally in treasury yields, we saw at least a considerable back-up in credit spreads that was, if nothing else, a buying opportunity. Now, of course, I have to acknowledge that the majority of those nine episodes we would characterize as a flight to quality, where there was some stress. We include, obviously the global financial crisis here. There was the European debt crisis.
                                                       There were along the way, some flights to quality that naturally come with the widening and credit. So maybe that's what makes this one unique. We don't really see any flight to quality behavior. There's not really any flight to quality catalyst. So to try and understand what's going to happen for credit going forward, we have to try to break down what's driving this rally in treasuries. With that in mind, Dan, the rally really started towards the end of last week and it came alongside a relatively strong unemployment report on Friday. What'd you make of that?

Dan Belton:                                            Yes, the rally did start to some degree on Friday. I thought that was somewhat curious. We had a pretty strong employment report by all accounts. The one reason that you could argue the rally was warranted was some of the wage data came in a little bit lower than expected with a revision to the previous month, but still overall a pretty solid jobs report. Then it really started in earnest on Tuesday after the ISM Services mess, which again, wasn't a really serious disappointment, but it did take a little bit of wind out of the sails of the reflation trade.
                                                       So as we've talked about in this podcast recently for this reflation narrative to really be born out and for inflation to start to accelerate at a rate of consistently above 2% meeting the Fed's new objective with respect to inflation, we would need to see really strong data coming in the spring and summer here. For even a small downside miss in some of these recent prints, I think that just represents a hit to the narrative that inflation is going to be as strong as some where expecting. Now, it certainly is possible. I think it's too early to write off this notion of accelerating inflation really coming up in the next few months, but it does represent a hit to that narrative, I think.

Dan Krieter:                                           But even what you just said highlights a dichotomy that I think we have to talk about, which is we saw treasure yields rally on Tuesday in response to a disappointing ISM number and we saw treasury rally on Friday in response to an employment number that some of the peripheral metrics didn't look as strong was still a plus 850 and NFP has to be considered strong and we rally. So I agree with you that inflation... we've talked about inflation. Everyone has talked about inflation being the most important determinant of rates and spreads going forward. So we can't really have this conversation without discussing the role that inflation's playing, and I think obviously given the move you had this week, it's not going to be groundbreaking to say that inflation concerns are dropping. Now we can drill down a little bit there and talk a bit about what that means.
                                                       Does that mean that the idea that inflation is transitory or ultimately not going to be a concern is that what's driving this, or is this a perception that the Fed is going to have to embark on ending accommodation either sooner or more rapidly than originally expected? I think that that is an important distinction to make because as we sit here today, it's difficult not to see inflation coming. Even today we had another record print on the JOLTS survey and I don't want to make too much out of JOLTS, but we see all the evidence of inflation coming from supply side bottlenecks. We obviously know the transitory impact there, but if we're going to get meaningful inflation, it has to come from the wage side. We have to see wage inflation and with JOLTS at all time highs and reports of people quitting their jobs at unprecedented volume and some frictions between hiring people back or people that may have ultimately just permanently left the workforce, still some lingering effects of stigma.
                                                       It's... I can at least see the ingredients for how wage inflation could really start up here and we actually... start a wage cycle. So I'm not saying it's going to happen, but I can at least see the possibility of it, which is why the timing of a big rally and treasury yields comes as a bit of surprise to me. So Dan, what's your thoughts on inflation here? Do you agree at least with my sentiment that the move in treasury yields here is an indictment of the reflation narrative and if so, is inflation not going to be a long-term problem, the fundamental drivers are just too deflationary, or is it a view on the Fed, or is it maybe a little bit of both?

Dan Belton:                                            Yeah, I am with you that this move in treasury seems to be primarily driven by lack of inflation concerns or capitulation of the reflation narrative. To me, it's more of the former of the two explanations you said. I don't think this is necessarily driven by expectations for the Fed to start to remove a combination prematurely. I really think it's more of an acknowledgement that inflation is going to be really, really hard to get this cycle, at least in terms of the accelerating wage inflation that we talk about. There's of course, supply side bottlenecks that are causing inflation and inflation prints have been high and will continue to be high. I think next week, the market is expecting about 4.9% year over year CPI growth.
                                                       So we are getting inflation. It's just not the type that is going to be sustained enough to cause the Fed to remove accommodation prematurely. That to me is what's driving this move in treasuries. I think the other thing is it's not unlike what we see in a lot of other asset classes. Credit is at all-time highs, equities are at all-time highs. If there is less of a threat of sustained, high inflation, it adds to the impetus that treasuries are not a bad buy here given how rich all other fixed income asset classes are.

Dan Krieter:                                           Yeah. Not just fixed income, but all asset classes. Then you can broaden that out to look at fixed income asset classes around the world with negative yields or whatever it is. We don't just spend time there, negative yields and the obvious implication there. So Dan, I think you're right. Capitulation really seems to resonate here with me is particularly the lack of really any response in other risk assets. We still know that there's a ton of investment assets bouncing around. We're seeing the RRP at almost a trillion dollars last week. Obviously that's more a commentary on what's going on specifically at the short end, but all of these are symptoms of just way too much cash, way too much investment assets without a lot of alternatives to go with it. If this is truly the view that inflation is going to ultimately not be a big concern, then what does that pretend for the next few years in terms of economic growth in the path of yields and the returns you're likely to get from financial assets?
                                                       Because if we truly aren't getting inflation, that means we're very likely to get a repeat of the economic recovery that came following the financial crisis, which was very low growth for a while, low volatility as the Fed continued to try to support markets with ample reserves and very low financial returns. We're headed there if we're not going to get inflation. So if that's where we're headed, this move makes sense, and we should mention, we have seen breakevens fall, but at least up until today, it's been a move as much in real yields that it has been in breakevens and we've seen real yields fall. That all makes sense. So if this is a big capitulation Dan, what does that tell you for the near term path of credit spreads?

Dan Belton:                                            Yeah, I think it certainly adds to the bias that we might not get a significant backup that we've been looking for to use as another entry point. If this move is sustained in treasuries and we do see low rates for a long period of time, that should ultimately anchor credit spreads at these narrow levels and potentially even propel them to new all-time tights. We've been talking about this Goldilocks scenario and how the two-sided economic risks could be bad for credit spreads on one hand, higher rates, higher inflation that could cause credit spreads to just move mechanically wider as investors demand wider spreads given higher treasury rates.
                                                       But on the other side of the equation, the one that we're now talking about as a more likely scenario is sustained low growth environment. Now, that could cause some transitory spread weakness where you have an increase in downgrades, but given a long-term low interest rate environment where Fed accommodation is pretty likely for the foreseeable future, that could keep spreads confined to these narrow ranges that we've seen over the course of 2021. All told, it just weakens my conviction that we're going to see spread weakness here coming up and we might be stuck in this low volatility, tight trading range that we're in right now.

Dan Krieter:                                           Above all else, for me, the move means that we haven't seen the lows in credit spreads yet. I think we are certainly going to see spreads break narrower, and I wouldn't be surprised at spreads in the 60, 65 to 70 basis point range before this is all said and done. That said, I haven't completely abandoned the notion that we're going to get a buying opportunity in August. I still think that deteriorating demand side and technicals in August are a really important trend. I also think that we're going to have for the first time the relentless onslaught of reserves into the system coming from treasury as general account. That's going to stop in August with the debt ceiling that could result in at least some slowing in the demand for investment assets, including credit spreads. I also haven't yet waved the checkered flag on this move and treasury yields.
                                                       We talked about how it hasn't exhibited any flight to quality behavior so far, and I don't expect that it will, but tone is weaker for sure in the past couple of days. I wouldn't necessarily say it's all over at this point and that there's no chance that spreads will not widen at least a little bit. Looking at of those nine previous episodes of a 20% rally in treasuries, actually the one that stands out as most applicable to me is a 20% rally or so we saw in 2010, which wasn't really much of a flight to quality so much as just a repricing of the market. Reflecting now less optimistic projections for the strength of the economic recovery following the financial crisis. We just saw yields rally and credit spreads widen a little bit. It wasn't like the widening in 2011 or 2012, where we saw spreads more significantly wider as a result of the European debt crisis or some actual flight to quality event.
                                                       We just saw a bit of a widening reflecting a slower economic recovery and I think we could see that. So I haven't given up on the notion that we're still going to see a buying opportunity here. That's why I'm still leaning neutral on credit spreads because I think we could get that widening with potentially weaker technicals, particularly on the demand side going forward in August. But to your point, Dan, I think that buying opportunity may not prove to be very significant, maybe 10 basis points if we even get that. Then this week's rally and charges really strengthens further the conviction that we're going to rally from there and probably through current levels in relatively short order. Now, the one caveat that I would say here, Dan, I'm interested to get your thoughts on it is that this week's move at least for me, leaves us exposed to the possibility that inflation could cause some less orderly market moves in the months ahead.
                                                       Now I think that's a low probability of that happening, but I'm also not yet convinced that inflation is truly just put to bed at this point. I will say though, that if we are going to see inflation become a concern for the market again, where we're talking about reflation and we see a rapid repricing higher of treasury yields and wider credit spreads, it would have to be an almost conscious choice by the Fed. Because I think the Fed certainly has the tools to fight inflation. We know they have the tools and the more hawkish than we expected meeting in last June made it seem at least to me, that inflation was already on their monitor. We'll get the minutes today that really shows us how much they were talking about it, but I didn't get the sense that the Fed had truly shifted its stance on inflation, that we were going to let inflation run hot, and I mean really hot for a while, before we make any moves to tamp it down.
                                                       If the Fed is again more dovish either in today's minutes or at the July meeting, as we see still more inflation prints and the Fed continuing to say, "We're not going to stand in the way of inflation." I think there is risk then that the market could move and it could be a more volatile move now, even if it's not the most likely outcome. What are your thoughts?

Dan Belton:                                            Yeah, I agree. I think the market has certainly moved and it's now no longer positioned for the potential for either higher inflation on a sustained basis or a real upside surprise to broad economic growth and productivity, which I think would cause a rather disorderly move higher in treasuries. That could also be accompanied by removal of Fed accommodation, which would exacerbate that move, and that's a scenario in which we could see a move of the magnitude similar to something like the taper tantrum, which we saw in 2013. Now we've said here and in our written work that we don't expect a taper tantrum like move to result from the announcement of Fed tapering, but we could see something disorderly like that if it were coupled by higher inflation data, higher productivity. That's something that as of this week, certainly I think the market is not really positioned.

Dan Krieter:                                           That is of course the only scenario also where you could see credit spreads not just wider in the short-term, but also the long-term. If you get a truly inflationary cycle, I think that's the only threat to wider credit spreads in the long-term. Other than that, if you have inflation proving transitory or the Fed moving rapidly to limit inflation, I think no matter what then you're going to get spreads that end up going narrower than they are currently. Before wrapping up today's episode, Dan, I want to talk about more of a longer-term storyline, but one that we're going to get developments on here in the next couple of days. So that's why we'll talk about it today to put it on an investor's radar, but we've talked many times about how the pandemic in many ways represented somewhat of a regime shift for credit spreads and that we're ultimately just going to see lower credit spreads than we've seen historically.
                                                       There's a few reasons for that. First we've talked about how the Fed backstop for credit is now certainly stronger than ever after purchasing corporate bonds all the way down to junk and even purchasing junk in some instances for the first time and the way that that changes the way investors engage with risk at this point. We've also talked about how there're more buyers now with rates super low. This is really a trend we've seen since the financial crisis is just buyers moving increasingly up the credit spectrum in terms of what's on unimproved lists or what's being targeted just to try and get more yield and the pandemic's not going to do anything to stem that. So these are drivers of long-term downward influence on spreads.
                                                       There's another one that arises from President Biden's bailout package, the ARPA package in March that I want to talk about and that's specifically a bailout for multi-employer pension funds that came in the ARPA package that will deliver as much as $86 billion, or potentially even more than that, of Federal money to underfunded, multi-employer mostly union pension funds with a lot of that likely to find its way into the corporate market. So we'll talk a bit about the details on what ARPA has done and what this bailout money could mean for corporate credit, but before getting into that, Dan, I just wanted to start with a bit of a discussion on the primary sources of demand for corporate bonds and how the buyer base for corporate paper looks. Where do pensions fit in that landscape?

Dan Belton:                                            Yeah. So pensions hold about 10% or so of the US dollar investment grade corporate market and that's been a pretty steady source of demand. The bigger buyer basis, at least as classified in the Fed Z.1 data are the rest of the world sector insurance companies, which includes life and property and casualty and then mutual funds and ETFs. Those three categories of the biggest holders have actually increased their share of the market over the past couple of years, primarily the mutual fund slash ETF sector. The retail investors have bought up in increasingly large share of the investment grade corporate market. That's something that we see with this weekly bond flow data, which up until the last few weeks has been an extremely strong, steady source of demand. These bond fund inflows averaging several billion dollars every week, but pensions have over the past 20 years or so been a pretty stable source of demand for corporate bonds. I think there's some reason to expect that pension holdings of US dollar corporates could increase given this bailout.

Dan Krieter:                                           To that point, just to provide a little more detail on what this bailout means. It's targeted specifically at underfunded, multi-employer pension funds and there are some criteria that determines what fund is underfunded or in critical stress here. But to cut to the chase, it's 86 billion or potentially more than that that's going to be coming. It's going to be coming to multi-employer pension funds, and then essentially that will be invested into either equities or corporate bonds. We don't know exactly what that mix is going to be. So the reason we're talking about it in today's episode is because when ARPA was passed in March of this year, the government agency that will be administering this program, it's known as the Pension Benefit Guaranty Corporation, they were given 120 days to provide further guidance for how pension funds can apply for this assistance and then what the assistance slash approval slash payment process will look like.
                                                       Also along that timeframe, the PBGC will announce any conditions that come with the Federal bailout money. For example, there are certain things that the PBGC cannot change as a result of it, but one thing they can change is they are allowed to make tweaks to requirements surrounding what pension funds can and cannot be invested in, things of that nature. So we know the 86 billion is coming, but we don't know yet really when it's coming. It could come as early this year. We may not see the money to start flowing until next year at the earliest with even the larger portions of the funds flowing not until 2023 or 2024 even potentially. We don't know yet what exactly the funds can be invested in. We know corporate bonds will be one of them. It's the only asset class specifically listed by ARPA as eligible for the stimulus funds.
                                                       But the bill also said there could be other eligible investment classes that will be determined by PBGC. So obviously the ultimate impact on credit spread that's going to come alongside what these details are and we're likely going to get them revealed by Friday. So that's why we're talking about it today. In our written work, we'll talk about it a bit more likely at the end of this week or maybe next week depending on the timing. I would just summarize things to say is that at the end of the day, this would likely be at least an impetus or heavier demand for corporate paper at some point in time in the next couple of years, which should put modest, downward pressure on credit spreads. Particularly the further out the corporate pension funds tend to buy. I just wanted to put a little more nuance on the conversation here, Dan.
                                                       Talk about how while it's 86 billion it's coming from the government, that doesn't necessarily represent the only source of demand coming from multi-employer pension funds as a result of this legislation because remember, these are very underfunded pensions, and as funding status goes lower and lower, sometimes we see pension funds increase allocations towards equity, which obviously offers higher potential returns, as a method of trying to catch up. So to the extent that's true, if a multi-employer pension fund then receives this 86 billion and becomes quote unquote well-funded again, you could see a rotation out of equities and into fixed income to restore the rule of thumb quote unquote 60-40 equity fixed income investment if there had been an overweight towards equities as a means of trying to catch up in these past couple of years.
                                                       So it's 86 billion, but then potentially more than that, reflecting any rotation that comes out of equities as a result of rebalancing. So, bottom line, we'll continue to monitor this, but I think it's a trend worth keeping your eye on for anyone invested in the corporate bond market and we'll see those details coming up by the end of the week.

Dan Belton:                                            Dan, before we wrap up today, for anyone who managed to make it this far in the episode, we just want to highlight that the 2021 Institutional Investor Global Fixed Income Research survey is now open. So if you find our podcasts or written work valuable, we would greatly appreciate your support in this survey. In order to vote, you can go to voting.institutionalinvestor.com and follow the prompts there. Or we will be shamelessly sending out some emails and Bloomberg messages begging for votes for this survey. Dan and I are hoping for votes in the Federal agency debt, investment grade strategy, short duration strategy, and fixed income strategy categories.

Dan Krieter:                                           I just want to echo what Dan said. A big thank you to everyone who's listened to our podcasts over the course of the past couple of years and is still listening to this episode now. That shows real dedication. Thank you for any support that you give us in the II campaign. It does truly mean a lot to us. So thank you for that. Then on a final programming note, we will not be recording next week. We have a monthly round table with the broader fixed income team. So we'll be back here in High Quality Spreads in two weeks. Thanks everyone for listening.

Dan Belton:                                            Thanks for listening to Macro Horizons. Please visit us at BMOCM.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 the FICC Macro Strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:                                             This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation. Together, BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses, generally, and not a research report that reflects the views of disinterested, research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell, or to buy, or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein maybe suitable for you.
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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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