Momentum Versus Value - High Quality Credit Spreads

Dan Krieter:

Hello and welcome to Macro Horizons High Quality Spreads for the week of January 25th, Momentum Versus Value. I'm your host, Dan Krieter, here with Dan Belton, as we discuss the future path for credit amid very supportive technicals but not so supportive fundamentals. We also provide an update on QT through the lens of the ongoing debt ceiling drama in the United States.

Each week, we offer our 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 emailed directly at Dan.Krieter, K-R-I-E-T-E-R, @bmo.com. We value and greatly appreciate your input.

Well, Dan, in the week since our last podcast recording, credit spreads continue to perform well, particularly in the primary market where we're starting to see some of the best executions we've seen in quite some time.

Dan Belton:

Yeah and we've been waiting for primary market executions to start to firm. And finally in the third and fourth weeks of January, we've started to see that. Over the past two weeks, we've had new issue concessions of basically zero on average. Order book coverage has been very strong, despite deals tightening by 28, 30 basis points from IPTs, which are metrics we hadn't seen for most of 2022. And we've seen that influence secondary spreads narrower. And if you look even deeper into the new issue statistics, we've had issuance even from financials which had struggled for most of 2022 and even part of 2021, that issuance has come very well received as well. So markets really not pricing in the recession that many strategists and economists are calling for and this rally in credit seems to continue.

Dan Krieter:

Yeah, I think you hit on a really important point there, which is the improving executions, particularly from the financial sector after years of under-performance. What are you attributing the sudden firming in primary market conditions to, or what are some of the factors you think that are really driving it?

Dan Belton:

It's really just attributable, I think, to broad optimism and that's been a characteristic of the price action so far in 2023. Markets are really coming off of this negative tone. We've seen most fixed income markets are no longer really pricing to a recession, in my opinion. We could see that throughout various metrics in the high grade market, which we'll talk about later on in this episode. But even fed funds pricing for instance, while there are a few cuts priced into 2023, 2024, the market implied path of Fed funds doesn't really go below the fed's neutral policy rate and is more consistent I think with this quote unquote, "immaculate disinflation" than it is with a recession leading to deflation, the Fed back at the zero bound anytime soon.

Dan Krieter:

Yeah, certainly the macro backdrop has played a key role here. I think there are a few other factors that play in the primary market worth just mentioning. The first being demand indicators seem to be picking up. I'll just highlight mutual fund flows after 120 billion dollar outflow in mutual funds last year. We've seen two consecutive weeks of inflows now. And we see outperformance in the belly of the curve. After last year we attributed under performance in the belly of the curve to there being a lack of natural buyer there with mutual fund helpful is just building on themselves. Now we see inflows coming back in and the belly of the curve outperforming. I think we're seeing demand not just for mutual funds but also other market participants increasing broadly here in January. Certainly the macro backdrop is part of that, but also I think it's worth mentioning here on the podcast as well is the disappointing supply we got from large American banks following their earnings blackouts after such heavy expectations.

I think coming into the year we and many market participants were expecting financial supply to fall, particularly from the large banks, but in Q1 with heavy redemption schedule, the thought was that the big banks would still be very active, but so far we've seen just 9 billion in supply. Two deals from the big six banks, and that is well below the average over the past two years of 27 billion in the post earnings blackout period and the second lightest of any quarter, the only quarter that was lower was coincidentally last quarter where we saw 8 billion in post earnings blackout. So it does start to seem like supply from the big, big financial issuers is going to fall more rapidly than maybe the market was expecting. And so then I think you see some more performance and better executions for the regional banks. The Yankee bank issuers are coming to market now. They aren't necessarily competing with the big six banks.

Dan Belton:

Yeah, in the first couple weeks of this year, issuance was really dominated by the regional and Yankee banks as there was an expectation that they were getting ahead of issuance from the biggest American banks. And as that issuance disappointed to the downside, we saw better executions. It's not surprising that's something that we were kind of expecting could happen. And you mentioned it too. This is the second quarter in a row we've seen lighter issuance than expected from the large American banks. It seems like while they're probably not going to go away from primary markets anytime soon, we've been expecting this normalization. We're really heavy supply started in the second quarter of 2021 and has been strong for the following six quarters really consecutively. Now we're starting to see this normalization. I think that's going to continue into 2023.

Dan Krieter:

So clearly some pretty strong technical tailwinds for the market here that have pushed spreads narrower. And now, I mean just looking since October, we're about 50 basis points narrower in the broad IG index. And the technical picture I think implies that we're just going to see continued narrowing. I mean these aren't just strong statistics, they're historically strong statistics compared to even periods of calm. So I think from a technical standpoint, we should see credit continue out to perform. And certainly I agree with your point you made earlier that markets are not pricing to recession, not even close to recession at this point. We've seen the highest outperformance coming from the lowest tranches of the credit spectrum, sees having their best year and decades so far. So clearly there's a strong risk on sentiment right here. But I think to transition to the next part of the conversation here, we have to start looking at fundamental values for credit spreads, both compared to historicals and compared to other asset classes. And I think really through any of those lenses, or at least most of them, credit starts to look pretty stretched at current valuations.

Dan Belton:

Yeah, so we talked about this in our weekly on Friday, and we looked at the current valuations in credit and the context of several different factors. So first we looked at model implied valuations and our model for high grade credit spreads currently calls them about 12 to 15 basis points overvalued at current levels. And that's not surprising. That's something that we've seen fairly consistently even though our model has tracked some of this enrichening that we've seen this year alongside looser financial conditions. But still model implied valuations are a little bit stretched. And that's something that I think a lot of investors are sympathetic to at 120 basis points in the Bloomberg Index, 130 in ICE, we're well below long-term averages even though there's something of a challenge macro backdrop over the longer term. We also looked at break even spreads, which is the amount of spread widening that would have to happen to offset a year's worth of carry.

And right now at the level of the IG index, there's about 17 basis points of break even spread, meaning that if spreads widen 17 basis points from here, that's enough to wipe out an entire year's worth of carry. To put that in perspective, 17 basis points would represent just about 22% of the 2022 range in credit spread. So not an outsized move would be required to negate a year's worth of carry. Of course, 2022 obviously representing one of the more volatile years on record. And then finally, and I think the most compelling argument for credit spreads being pretty stretched right now at current valuations, we looked at credit relative to other asset classes. So first we looked at relative to treasuries and instead of looking at the spread, we looked at the yield ratio of credit, which is the ratio of high grade yields to underlying benchmark treasury yields.

And what we found there is that yield ratios are currently at extreme levels. They almost have never been tighter than they currently are, just a small move narrower and credit spreads would be required to set all time tights and yield ratios. We also take credit spreads relative to MBS spreads the five year, 10 year treasury blend. And that shows that while credit spreads usually offer a fair bit of yield enhancement over that metric and mortgage backed spreads, that's been eroded as of this year and credit is actually now trading through that metric of mortgage spreads. The only metric whereby high grade credit looks somewhat attractive is if you look at it relative to high yield. And so credit spreads right now we're trading about 10 to 15 basis points narrower than their long-term average. High yield index spreads are about 115 basis points narrower than their long-term average.

And so what that's telling us is that not only are credit spreads narrow in the context of their historicals, but investors are not being compensated for moving out the credit spectrum. And that's a telltale sign that markets are not currently pricing to recession or anything close to it. And so I think the next question becomes, if there isn't too much value in credit right now, what is going to send credit spreads back into a more fair trading range relative to historicals?

And it's not clear what that's going to be, in my opinion, at least in the near term. We've already seen some early Q4 earnings come in and they've been fairly underwhelming. They've surprised the downside by more than they have in any quarter through this point since the onset of the pandemic. And keep in mind that earnings expectations had been revised lower by a significant margin. So that's telling us that markets are starting to really look past Q4 earnings. And so if earnings are not going to kick spreads wider, I think the next question is what's going to?

Dan Krieter:

Yeah, you shared some eye-opening statistics there and I think you touched on earnings and it's important to note that we're seeing weakening Q4 earnings at the same time that we're seeing more concurrent economic data starting to imply that the consumer might be weakening here. In Q4 when earnings are now starting to look not so great, all metrics of the consumer were still relatively strong. So if the consumer's rolling over here, I think that bodes potentially poorly for the path of earnings estimates throughout the rest of this year. And that's a very troubling juxtaposition with the current level of credit spreads that you just laid out so succinctly. So I think coming into the year we're of the view that spreads would perform during the first quarter and that's happened. But I think as credit has performed, the risk reward proposition offered by credit spreads has just deteriorated significantly.

And by that I mean given how narrow we are now, even just from a yield ratio perspective, if we're going to see a significant move in credit spreads, and I'll define significant as say a 20 basis point moving either way, I think the odds are overwhelmingly tipped towards it being a widening event. So even though we see supportive technicals, and I'm with you on the macro environment, that optimism for a soft landing is likely going to be maintained for a while here just given where spreads are now, I think we have to turn more neutral on credit spreads and really my key theme going forward is likely to be one of decompression. You talked about what's going to kick spreads wider. I don't see anything in the immediate term, but the answer would have to be that we'd see not just increasing fears of recession because those are already there.

Recession is all that's talked about. We see recession indicators at levels that are rarely seen throughout history and yet credit markets aren't pricing that. So it's not just discussion over recession. We'll need to start seeing more evidence that recession is actually happening. And if that happens, spread widening is going to be led by lower rated credit tranches that are already so tight.

So for me what that means is we came into the year not just expecting spread tightening, but we favored trades in higher beta credits. Our IG focus puts us in triple Bs. That's about as far down as we can go, but I think now also makes sense to start looking at up in credit quality trades, even just switches. So you're not necessarily moving underweight credit here, but you take advantage of some of the spread narrow and we've gotten in higher beta sectors and moving up in credit quality for fear that the next move in spreads will be wider, because I do think it's more a matter of when not if at that point, and then it's going to become a question of timing, which is notoriously difficult, but I'm still of the belief that engineering a soft landing here is going to be extremely, extremely difficult for the Fed.

And my personal base case is that it's not going to happen. So if we see more meaningful slowdown, increase in risk premium for credit spreads into the second quarter, that would be my base case. But I'm curious on your view.

Dan Belton:

Yeah, I think a soft-ish landing is still possible. I think the Fed is still determined to generate some slack in the labor market and I think they'll get there. The question to me is, is this increase in unemployment say going to be enough to knock credit spread significantly wider?

And I do think at some point later on this year we're going to get a risk off move and I'm targeting late spring or summer for that move to happen. And that's going to present I think probably a decent buying opportunity for investors. And so I agree with your sentiment that particularly if you're an investor with a longer time horizon moving up in credit probably makes sense right now and anticipation of a move like that. And timing is going to be very key. So I think if you are a more tactical investor, I think maintaining market weight or even slightly overweight some of the higher beta sectors in the near term makes sense. But then later on this year, I think it's going to be very important timing, that risk off move, that I think a lot in the market are still expecting is going to happen.

Dan Krieter:

While we're on the topic of what markets are pricing right now, we've talked about how markets aren't pricing a recession, but maybe that isn't true. Is it that markets are pricing for a soft landing or markets are pricing for a mild recession? I guess I'm getting at, do you see a big differentiation between a quote unquote "soft landing" and a mild recession that maybe wouldn't impact credit as much, just given how strong balance sheets are coming in?

Dan Belton:

Yeah, I think that's a really important point and it's probably the case that it's not very easily discernible the difference between a quote unquote "soft-ish landing" and a very mild recession. Most economists seem to be forecasting the quote unquote "mildest recession that we've had in recent history," and I don't know how markets price that differently than a soft landing. And I think it's probably not clear how financial assets would perform in that very, very mild recession scenario. I don't know that credit spreads, especially in the investment grade space, I don't know how they would react in a very, very mild recession. It's ultimately going to come down to the areas of the economy that are affected in the degree to which they are.

Dan Krieter:

Yeah, it's a great point that I've heard you make before that the difference between a mild recession and a soft landing isn't entirely clear, and if you get a mild recession, credit spreads would likely perform pretty well throughout. But I would view it in agreement with what you said earlier, that I do think there will be a period of spread widening where there's uncertainty, particularly heading into a recession with the central bank in restrictive territory and the expectation that they will remain restrictive. We haven't necessarily seen this type of environment in a very long time where we're heading into recession where the Fed isn't likely going to suddenly switch to accommodative in a big, big way. I mean that's possible, but that would only happen if we saw some type of contagion like big, big downturn even to deflationary environment. So I'm not saying that that's a horrible environment for credit where we're going to see massive widening where a mild recession that doesn't come with Fed easing is going to suddenly drive spreads much, much wider.

I don't think that, but I think that the uncertainty there, even in a mild recession outcome would drive a period of under performance that would then be a buying opportunity. So I just think given where spreads are at this point, well momentum is on their side and I wouldn't expect a big move wider in the near term. I think if I'm looking three, six months down the road, I think spreads are going to be wider than current levels. And so starting to move up in credit quality and tactically take profits where it makes sense, I think is the right stance.

And I just want to quickly touch on one last factor driving that view before we go here, and that's quantitative tightening. Much has been made of quantitative tightening over the past half year really since the program kicked off in June. And quantitative tightening is naturally a credit spread widener insofar as it's the opposite of QE.

If QE pushes investors out the credit spectrum, QT brings them back in and should see spreads widen. The high level takeaway I want to make on QT right now is that we still really haven't seen almost any impact from quantitative tightening at this point due to changes in the treasury's cash account at the Fed or the TGA, which has fallen substantially since June, which represents a mechanical inflow of reserves into the financial system. So as QT removes reserves, declines in the TGA put reserves into the system such that we've seen total liquidity in the financial system. And by total liquidity, I mean the RRP plus bank reserve balances has actually increased since the beginning of QT. Now I will note that that has come entirely from the RRP. We have seen a drawdown in bank reserves, but the point remains that liquidity has remained unaffected by QT thus far.

So what does that mean for credit spreads? It means a QT really hasn't had any impact yet, and because we're now in a debt ceiling showdown where no one is expecting any type of quick resolution, in fact this is potentially the most contentious debt ceiling we've had thus far. We're going to see treasuries cash balances continue to run down, likely reaching levels very near zero, which is another 300 plus billion dollar drawdown, which is going to continue to mitigate any impact of QT on the economy for a while here. So that would lend further weight to the idea that spreads can continue to hold in relatively well in the near term. The other side of that coin though is that once we do get a debt ceiling resolution, treasury will increase its cash balance in a relatively short amount of time back up to their preferred habitat, which is in the 700 billion dollar range, six 50 to seven 50 billion, and that's a reduction in reserves.

That's going to be coming alongside QT playing out at 95 billion a month. And so that's going to be a pretty sharp reduction in reserves. That could be a spread widener toward the middle of the year, probably more towards the summer months, July and August.

Obviously this situation is very fluid and we've seen some market pundits in recognizing the story I just laid out, potentially saying that QT might have to end early to avoid that, that would not be my base case, particularly with the existence of the standing repo facility here. The Fed has a buffer for there to be more volatility in reserves, and we've seen a few Fed governors on record saying that they would like to see some activity in the standing repo facility potentially before considering terminating QT. So I wouldn't think the QT would end, and so later in the year, the path of reserves in the finance system is just another factor that would potentially imply some degree of spread widening later in the year.

Anything else, Dan, before we go?

Dan Belton:

No, I think we can wrap up there. Thanks for listening.

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