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Is This It? - High Quality Credit Spreads

FICC Podcasts 21 juillet 2021
FICC Podcasts 21 juillet 2021


Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the ramifications of the recent bout of Treasury market volatility including the modest widening in credit spreads and discuss whether more weakness will be realized. Other topics include the threats to global growth and rising inflation and front-end dynamics ahead of the month-end debt ceiling deadline.


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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 Horizons, high quality spreads for the week of July 21st. Is this it? I'm your host Dan Krieter here with Dan Belton, as we discuss the recent widening in credit spreads and whether or not we should expect more in the near term. Finally, we wrap today's episode with a brief discussion on short end dynamics with the July 31st debt ceiling deadline rapidly approaching.

Dan Krieter:

Each week, we offer our view on credit spreads, ranging from the highest quality sectors such as agencies and 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 dot Krieter, K R I E T E R at BMO dot com. We value and greatly appreciate your input.

Speaker 3:

The views expressed here are those of the participants and not those of BMO capital markets, its affiliates, or subsidiaries.

Dan Krieter:

Well, Dan, the move in Treasury yields has without doubt been the dominant theme of the past couple of weeks, but sort of hidden under the surfaces, we have gotten a little bit of a backup in credit spreads here. High quality sectors in the SSA sector are three to five wider and IG corporates are eight, nine, maybe even 10 basis points wider in the past couple of weeks. And our listeners will know that we've been looking for a buying opportunity and credit in the July, August period here where economic data would start to matter more and technicals weren't as supportive. So I guess the question on top of everyone's mind now is, is the 10 basis point backup we've gotten, is that the extent of the buying opportunity or will we see more widening? And I think that's obviously the topic we have to focus on here first today. So Dan, why don't we start by, let me just ask you, how has your view on credit spreads evolved in the past couple of weeks with the big rally in Treasuries?

Dan Belton:

Hey Dan, so I think certainly given the volatility in Treasuries some amount of under performance in credits should be expected. And then as long as this continues, we could see a little bit more weakness. I don't tend to believe, in my base case at least, that we're going to get another significant leg wider in credit spreads. I don't expect we're going to see another 15 basis points. Now in the near term, we could see some more weakness, but we would have to see the global growth picture deteriorate pretty significantly before we got another real serious leg wider. And there's a lot of structural reasons to expect that credit spreads are going to be pretty well anchored this time around. But I do think if we get another couple basis points of weakness, I'm going to start to look to recommend long positions in credit.

Dan Krieter:

Yeah. And I think my view is pretty well aligned with that, but let's dig a little deeper on that. Let's play that out and really look at things from both sides to see really what is the argument for wider spreads here? Because we certainly have seen episodes in the past where that's happened. I think the most applicable environment is the environment of 2015 and 2016, where we saw credit spreads back up as much as a hundred basis points alongside a slowdown in emerging market economies that bled into the US economy. And we saw multiple indicators of economic growth in the US start to slow in 2015, 2016. I think that's what we're dealing with right now with the Delta variant, obviously that has been the key driving force in the Treasury market rally. And if you look at what the Delta variant is really going to mean for the global economy, I think high level, the main impact of Delta is a threat to growth in areas of the world that have lower vaccination rates. Here in the US, I actually don't see a massive impact from Delta.

Dan Krieter:

I don't think that the Delta variant is going to really meaningfully change anyone's consumption behavior with the economy now really reopened. Certainly we'll see pockets here and there, where there could be a spike in COVID cases, in a particular community center or school. And we could see localized shutdowns there, but from a high level, I think the bar to reintroduction of widespread lockdown in the US is quite high and won't come unless we see any evidence of meaningfully reduced effectiveness when it comes to the vaccines. We haven't seen that so far.

Dan Krieter:

Early data coming out is that the vaccine remains mostly effective against hospitalizations or deaths against the Delta variant. Obviously from an infection standpoint, Delta is demonstrating lower efficacy, but I think people will accept the risk of becoming sick as long as there's not a fear of a more dire outcome. So at least at this stage, I don't expect to see a real impact on consumption domestically, but the same cannot be said abroad. And that's obviously what we're seeing with the big rally and treasuries. I guess the question for me is, at what point does the slowing of global growth expectations transition from a small hiccup in credit that we'd consider a buying opportunity to maybe something more meaningful, like in 2015, 2016, when we saw spreads widened a lot more significantly.

Dan Belton:

I agree that the 2015, 2016 experience is probably the most applicable one that we have in recent memory. But I view that more as a maybe not worst case scenario, but kind of bad outcome from where we are right now. I think it's possible that the slow down abroad does not get so bad that it impacts the domestic economy in the same way it did five, six years ago, but that is certainly the possible outcome. I think all that would take is for the current situation with the Delta variant to just get worse over the coming weeks and months. And then we could see more widespread lockdowns abroad, which would in time feed through to energy prices and other goods markets. Now with respect to credit spreads, you talked about the 100 basis points of widening that we saw in 2015, 2016. I don't think even if we did see a similar impact on the domestic economy, I don't think we would see necessarily the same amount of spread widening for a few reasons.

Dan Belton:

First we've talked about how lower rates generally correlate with narrower spreads. Ten year Treasury yields are about a hundred basis points lower today than they were before the 2015, 2016 flight to quality. But it's hard to imagine anything less than a very severe shock causing credit spreads to widen now from about 80 basis points to 180 basis points or so. And there's the impact of the fed and their demonstrated willingness to step in and backstop corporate markets. I think that would enhance any perceived buying opportunity given, about moderate degree of weakness, call it 20 to 30 basis points or so. And then there's just the accumulated experience, 2015, 2016, about a hundred basis points of widening probably looked like a decent buying opportunity after a little bit of hindsight. So I think if we did see this global slowdown realized, and if it did feed into the US economy, we could see some amount of backup in the 30 to 50 basis point range in credit spreads, but that's again not the worst case scenario, but probably a bad outcome from where we sit right now.

Dan Krieter:

Again, I'm in agreement with you. I really don't see a significant widening in credit here from a global growth perspective. It would truly take a redefining event, I think for spreads to re-widen in here. At 120 to 130, depending on what minute it is right now in Treasuries, we've already priced into significant revision, if you will, of global growth prospects. And certainly that can get worse. But I think then to your point about accumulated experience and investors will just slide back into the mode that they've grown comfortable with in the past decade, which is yield enhancement is the name of the game. We're likely to have low growth for the next couple of years. And so any incremental yield you can get is where you want to be playing it. It would take for me, most likely widespread failure of the vaccine or something similar where people are again, afraid to emerge whether you're in a vaccinated jurisdiction or not.

Dan Krieter:

I think it's just human nature to sort of be putting the pandemic in the rear view mirror at this point, despite Delta. And it would take almost a return to the mentality of early 2020, I think for growth concerns to result in still further significant widening from here. Which is why for me, somewhat counter-intuitively given the big rally in Treasuries here, the main threat to credit spreads remains actually inflation. And we've seen inflation coming in hot. Everyone expected that, it's maybe even a little hotter than people thought, but it continues to be driven by pockets inflation here and there that are just idiosyncratic factors related to reopening. We all know the used car story, things like that, that are expected to clear up. But I just want to say that given Delta, you can actually make an argument that inflationary concerns might be a little bit exasperated here by Delta.

Dan Krieter:

And again, I'm talking about the divergence between the vaccination rates in north America and perhaps the rest of the world that drive the global supply chain. Obviously we know that a lot of the driving force behind this quote unquote transitory inflation has been a temporary disruption in global supply chains as a result of the virus that will now theoretically clear up. But the Delta variant is inherently a continuation of those supply chain disruptions, right? You could see those supply chain disruptions last a little bit longer. And then if we see a weak consumer, we've already seen the University of Michigan confidence survey starting to turn down, consumers already sort of becoming wary about higher prices here. You could see a sort of worst case scenario for corporations where, because of inflation, the cost of their inputs is going higher and higher, and they're not able to pass those costs along to a weaker consumer or a consumer content to wait for prices to fall. And then that, for me, potentially unleashes more downgrade default fears that could push spreads meaningfully wider.

Dan Belton:

Yeah. And to that point, in a sense, it's almost the worst case scenario from the standpoint of inflation is high today, but inflation expectations, at least if you look at market based measures, ten year breakevens are no higher today than they were in the first and second quarter of this year. The consumer has a lot of reason then to wait to make some of these bigger purchases, to wait and make a car purchase or other consumer durables if they think that inflation is high right now, but maybe going to come back in the next few months. So that just adds to some possible weakness we could see in the domestic economy, just from the standpoint of the consumer.

Dan Krieter:

It's a great point, but there is some nuance there because what you're talking about, the lack of growth because people are waiting for prices to come down, I think that's just a component of the slower growth story that ultimately I think translates into a yield grab mentality that sends spreads to new lows through the levels we've seen in the past couple of months that were historical lows. The concern for me would be, if you start to see the opposite of that, where you see inflation actually start to pick up, certainly we've seen evidence of wage inflation or pockets of wage inflation with the struggle to get workers back from the sidelines, whether that's because of health concerns or family concerns or stimulus, who knows. So as we get into the fall months and extraordinary stimulus starts to run off, are we going to see those workers return to the labor force that's going to ultimately ease those wage pressures? Or could we actually see actual inflation?

Dan Krieter:

I tend to think not, but certainly after the market move of the past couple of weeks, inflation to me is the key threat to credit spreads here. And that sort of transitions the conversation nicely to next week's Fed meeting, which is suddenly important now because we've seen the shift in the central bank's attitude toward inflation. Obviously we know about inflation targeting and the Fed's willingness to tolerate a higher inflation rate, but that's been more words than actions. At least to me, if you look at the June meeting and the minutes from the June meeting, it does seem like we heard the Fed start talking about inflation being potentially more persistent or higher than they may have thought. And the June meeting as a whole seemed a bit more hawkish.

Dan Krieter:

So if we go to the July meeting, is the Fed going to continue down the path of tapering and maybe be more tolerant than inflation in words and action, or are we going to see the Fed double down on letting inflation run hot, potentially introducing some more, this is not necessarily going to happen in the July meeting, but over the course of the next few Fed meetings, are we going to see the Fed start to talk about employment targets, potentially targets for employment in certain sectors of the labor market and really drive the narrative that they're going to tolerate high inflation? Or is it going to be the other way? Because if we see the Fed really reiterating its commitment to inflation running hot, I think that could be a negative for credit at this point. Not my base guess, I think the Fed is going to continue down the path of tapering here and that ultimately being constructive for credit. Maybe even that's a little counterintuitive. What's your read on the Fed situation?

Dan Belton:

Yeah. So this meeting is going to be pretty interesting I think. Chair Powell on one hand has to acknowledge and speak on the risks to the global economy, but he also, I think, has to keep the potential for tapering later this year on the table. And so it's going to be interesting to see both how he perceives the global risks. And then if there's any clues to what the Fed's reaction function is given these risks. I am more of the view that while I think he's going to keep the potential for tapering on the table, he's going to reiterate the comfort that the Fed has with inflation where it is right now. We've had very high inflation in the second quarter, but if you look at inflation expectations, like I just talked about a few minutes ago, breakevens do not suggest that we're getting this type of runaway inflation that's going to be characterized by expectations of inflation, be getting more inflation and so on and so forth.

Dan Belton:

So I think that adds a little bit to the Feds comfort. Now, inflation breakevens aren't necessarily the same as a consumer based measure of inflation, but generally we're not seeing much of a move in inflation expectations over the longer term. So I think that adds to the Fed's comfort with where policy is right now. Now as far as the Fed tapering or not, that doesn't really do much for the global growth story. That's going to be more frankly of a health crisis than a matter of Fed policy. So Fed effectiveness is going to be fairly limited as it relates to this most recent flight to quality bid.

Dan Krieter:

Yeah. I want to be very clear on one point after what you just said. I'm not saying I expect there to be runaway inflation. I don't think there will be. I'm just trying to make the case that inflation is actually the largest threat to credits treads, even after what we've seen in these past couple of weeks with the big Treasury rally. And you talked about the Fed's tapering plans and I agree with them and sticking with the theme of paradoxes here, I actually think the Fed moving away from tapering plans could be a negative for credit at this point.

Dan Krieter:

Because the Fed's tapering plan has been so well telegraphed so well understood by the market and so strongly expected to becoming... July may be some hints, Jackson Hole, they're going to talk more meaningfully about it. End of the year, we'll get an announcement for implementation either late this year or early next year. If the Fed doesn't follow through with that, I think that may even end up sending a signal to the markets that, okay, so the Fed is more concerned about growth than maybe we thought and things could be worse than we thought.

Dan Krieter:

And maybe that's a negative for credit, both from growth perspective. And then also the ramifications on what it could mean for inflation that sort of high inflation was a weak consumer outlook that we were discussing earlier on the podcast is potentially the worst outcome for credit. I think the Fed derailing tapering could be a step towards that. So I guess just to bring this all together to sort of a bottom line, I think this might be the extent of the buying opportunity or close to it. I wouldn't be surprised if spreads leak a little bit wider, particularly in the summer with thin markets, but I don't think we're going to see more significant widening.

Dan Krieter:

Now it wouldn't surprise me as spreads continue to bang around at a little bit of a higher end equilibrium here for the next couple of months, particularly with technicals, not really on the market side ahead of expected supply in September. And people potentially looking into the primary market rather than putting money to work in secondaries here, but I don't think there'll be much more widening. And then ultimately, later on in the year, once we get through sort of this soft patch from a technical perspective, if you look to forward to October, November, maybe even December, it wouldn't surprise me to see spreads breaking through the lows that we've had already. Is that generally in line with what you're expecting as well?

Dan Belton:

Yeah. I think once we get through this period of volatility, I think spreads are going to be fairly well bid. The next hurdle over the medium term I see is not the Fed's announcement of tapering, but the actual mechanical impact of Fed tapering, allowing more treasuries and MBS to clear the market without its support. But in the medium term, I'd say I'm fairly constructive on spreads.

Dan Krieter:

Yeah, we're on the same page there. I do think that could be a headwind for spreads, but I think that's more of a 2022 story for the second half. For me, as long as we don't get another significant reprising of the path of COVID with vaccine efficacy of being called into serious question here, I think the path looks pretty clear from here on out for spreads to resume narrowing after this little mini buying opportunity that admittedly, maybe wasn't as significant as we were hoping in the months leading up to this buying opportunity we were expecting.

Dan Krieter:

All right, Dan. Well, before we wrap today's episode, I wanted to just talk about the short end a little bit. We haven't talked about it much in recent episodes and frankly that's because it really hasn't been a whole lot to discuss, but now we are what just 10 days away from the debt ceiling deadline, where the expectation was some of the short end dynamics could start to change.

Dan Krieter:

And I guess backing up, we've seen swap spreads generally trade in that same range they have for the majority of the year, a couple basis point range given how anchored everything is in the short end, but now the debt ceiling is coming. Maybe things are going to start to shake loose. But I guess let's start our conversation in the short end here, looking at the Bloomberg page this morning, Treasury's cash balance is still at about 700 billion.

Dan Krieter:

Now guidance they gave us at the last quarterly refunding was that they were going to drop that cash balance to 450 billion. That's 250 billion in the next 10 days or less. That strikes me as a lot, which made me start to think, okay, well then maybe Treasury isn't going to get their cash balance down to 450. Certainly over the course of the past year, we've seen Treasury run much higher cash balances than they had laid out as expected in the quarterly refundings. Trouble for me though, is that at least my understanding of it is that that 450 billion is how Treasury was interpreting where their cash level had to be from a debt ceiling perspective. So what are your thoughts there?

Dan Belton:

Yeah, it's hard to say. It's hard to predict where Treasury's cash balances will be in the next 10 days. You could see a scenario potentially where Treasury comes out with a different interpretation of what the law states their cash balances can be at the debt ceiling deadline, and maybe they come up a hundred billion or over that 450 billion mark. Regardless, I think we're going to see some further declines in Treasury's cash balances, maybe 250 billion, maybe a little bit less than that, but that's just going to mean more pressure on the front end that we've been seeing for most of this year.

Dan Belton:

So our RP volumes are going to remain high. Bill issuance is going to remain low and get lower over the next couple of weeks. But then after we pass this debt ceiling deadline, and eventually get to a resolution, we're going to start to see these pressures that have characterized most of this year start to fade. We're going to see this collateral cash imbalance start to normalize gradually. I don't think it's going to be something that happens immediately after the debt ceiling resolution, but things should start to gradually move in the opposite direction.

Dan Krieter:

I think that's what we're all waiting for here, but really trying to hammer it on when that's going to happen is very difficult because I'm certainly not expecting them to reach a resolution by July 31st on the debt ceiling, which means then we have to start trying to figure out when the drop dead or X date is. And I think obviously everyone knows there's way less certainty around that now. Certainly we don't have any detailed calculations for when that's coming. We rely on the same resources as everybody else. And it does seem like it will be September, October, but we do have Secretary Yellen coming out recently in the press saying that it could happen as early as August. And her fear is they're going to run out of cash while the lawmakers are on recess in August. I don't know. I can't know how realistic that is or if she's just trying to sort of go Congress into passing a suspension or raise of the debt ceiling before July 31st, we've seen Treasury of Secretary sort of speak somewhat from a doomsday standpoint on this just to get Congress into action.

Dan Krieter:

So what do we know about when the extraordinary measures starts? We know that Treasury is not going to be running up its cash balance during that time. Obviously not meaningfully, maybe a little bit here and there, but not meaningfully given their inability to issue debt freely, and that's going to stretch for the next couple of months. So I just can't see at this point, any meaningful changes to the ample reserve regime that we have at the short end that's keeping front end rates extremely low. I think they're going to stay pinned very, very low here. LIBOR OIS is what five basis points or less, last I looked reached a low of around two basis points. Our view that it could reach zero in the short term. It hasn't been realized, but in spirit it has held relatively well. And I wouldn't be surprised by some more narrowing there in the next couple of weeks.

Dan Krieter:

So I think short end spreads really just confined to the range without really any hope to get off the mat here, at least until we have a more lasting resolution to the debts, I think at some point in time in the fall. And so from a swap spread perspective, I think steepeners that trade has performed for us. We're like six basis points in the money on that. And the drivers of it are still in place for me. I think you still see front-end rates pinned down. The SLR is still out there looming. We don't know when that's going to come. Who knows if it's going to come year at this point, but it could come any day really and if and when it does, I think that would be a widener for belly spread. So I still continue to like steepener. One quick note on the debts thing that we didn't cover, Dan, is the potential that it turns into an event for credit.

Dan Krieter:

It's obviously not a strong possibility, but if you go back to when S and P downgraded the US government in 2011, when the debt ceiling was really maybe the most contentious that I can remember at least, it came down to the very last minute. We saw spreads widen and we saw a real investor anxiety around the debt ceiling. Now we've gotten more used to it since 2011, for sure. But this episode has the makings of potentially coming down to the wire. Do you see a scenario where investors maybe get a little rattled by the debt ceiling and you see any impact on credit?

Dan Belton:

Yeah, it's certainly a possibility that we have to acknowledge. I think the political climate in Washington is very divisive right now. And politicians could certainly use this as a bargaining chip, it's possible that we see that... I don't know that it gets as far as it got in 2011, it's possible, but not in the base case.

Dan Krieter:

I'd say the ingredients are there, I agree it would be not a smart move to make that a base case expectation, but the ingredients are certainly there from a political perspective. And I don't think... It seems to me like the market isn't as concerned about the debt side in this time around. With each episode, we become less and less concerned with it. And I think that's the right interpretation, but keep that on the radar, because that could be something that's a more important trading theme in the next few months with ramifications, both for potential yields and credit. And then, Dan, one more short end topic the thought we should touch on today given its timeliness was some releases from the ARRC this morning regarding the transition from LIBOR to SOFR. I guess the headliner being that they expect to have term SOFR in place shortly after the July 26 cut over from inter-dealer trading referencing LIBOR to now referencing SOFR, this was in our base case from essentially right when they announced that July 26th, 27th deadline.

Dan Krieter:

So this comes as no surprise, really. Maybe there was a little meat on the bone with some recommendations that ARRC made regarding the usage of term SOFR. I noted that they talked about what asset classes they recommended term SOFR being used for specifically containing that to business loans, some syndicated loans, certain securitizations, they did not recommend it for use with floating rate notes. So it looks like we can continue to look forward to using look backs and lockouts and observational shifts and all that fun stuff with FRNs, but I think the market's pretty well understanding of that at this point. One other thing there, they talked about the use of term SOFR and derivatives and while they said that they continued to favor backward looking SOFR for the majority of derivatives, they did recommend potentially using term SOFR and derivative markets used to hedge assets that are denominated in term SOFR.

Dan Krieter:

So that's at least something worth noting. There is currently no derivative market that trades term SOFR, so that will theoretically have to develop. And that's one of the many things actually we're looking for in the next six months, it's going to be crucial from a transition away from LIBOR perspective, which rate are these banks going to select as their lending rate? Will it be SOFR? Will it be BSBY? Things have been pretty quiet on the BSBY front, but we've seen some more loans coming out, public loans that you can find on Bloomberg coming out, referencing BSBY right before he walked away from the desk to record this podcast. Actually, I think I saw some chatter on another issuance from a Canadian bank referencing BSBY. So BSBY starting to crop up again, it's really just going to be a crucial couple months here.

Dan Krieter:

Are we going to see some significant pickup in BSBY denominated assets that will then also have to be hedged term SOFR assets that will have to be hedged potentially with term SOFR derivatives, what's that going to look like? Nothing we can really comment on today, just be on the lookout because it's going to be a significant factor for derivative market participants specifically over the next few months, as we start to see a more meaningful shift away from LIBOR. Dan, did you have anything else from the ARRC announcement that we should talk about a little bit?

Dan Belton:

No, just to reiterate, this was pretty much as expected. The ARRC stated that it would have the term rate available shortly after that July 26th switchover, they just today really reiterated that guidance. And then the guidance about use of term SOFR versus overnight SOFR, we've known that the regulators are going to prefer the use of overnight SOFR. We talked about the potential for cannibalization of term SOFR in a scenario where too many users were referencing term SOFR not enough trading overnight SOFR derivatives, which would then make a problem, the fact that term SOFR is based on overnight SOFR derivatives, so then every product that is able to use overnight SOFR, the ARRC is going to recommend that they use that, whereas term SOFR sort of reserved for the products that cannot use overnight SOFR in arrears.

Dan Krieter:

Yep. Term SOFR is there only if you need it. Okay. Well, I think that wraps up our conversation for today. Before we go, on a quick programming note, we're going to be off from the Macro Horizons high quality spreads podcast for a couple of weeks here because my steam colleague Danny Belton is getting married and headed on his honeymoon. So I'm going to wish Danny a big congratulations, give him a standing ovation and assume everyone else is joining me in that. So Dan, enjoy your honeymoon. Congratulations. And we will be back here, come August.

Dan Belton:

Thanks for listening.

Dan Belton:

Thanks for listening to Macro Horizons. Please visit us at B M O C M dot com slash Macro Horizons. 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 dot Belton, B E L T O N at BMO dot 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 3:

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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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