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Holiday Sales - High Quality Credit Spreads

FICC Podcasts 23 novembre 2021
FICC Podcasts 23 novembre 2021


Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the outlook for spreads into yearend from the standpoint of technicals, fundamentals, and the macro picture, each of which point to modest weakness in the weeks ahead. They also discuss the recent move in front-end swap spreads including the drivers and near-term outlook.


Transcript will be posted shortly.

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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 November 23rd holiday sales. I'm your host, Dan Krieter here with Dan Belton. As we discuss the recent move wider in credit spreads, as well as our expectations for the rest of the year. Finally, we touch on the recent move wider and swap spreads, what's driving them and what to expect going forward.

Dan Krieter:
Each week, we offer our UN credit spreads ranging from the highest quality sector 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, it's affiliates or subsidiaries.

Dan Krieter:
Well, Dan, the title of our episode today is Holiday Sales, a reference to both our expectation for heavy corporate supply following Thanksgiving, as well as our expectation for some potentially discounted pricing and corporate bonds between now and the end of the year. And both of those facts I think were put on full display last week.

Dan Belton:
Yeah. Then last week we had 56 and a half billion in gross issuance in high grade corporates. That was the third heaviest week of supply this year, which is no small feat considering this to the second heaviest year of supply on record. And to your point about discounted pricing, we saw that elevated supply lead to some secondary market weakness. So in primary markets, we had elevated new issue concessions of about four and a half basis points. That's up from the year to date average of one basis point. Order book coverage slipped to about two and a half down from the year to date average of three times and spreads on the index level had their worst week of performance since the week ending March 9th, widening about four basis points. And even though there's some event risk on the horizon and this supply calendar is going to be really heavy going into your end, it seems like issuers are still bent on getting this supply priced while rates and spreads are still more or less constructive this year.

Dan Krieter:
Yeah, I think the worst week at index level being a four basis per point widening really speaks to just how stable things have been in credit. I mean, we've been in an 11 basis point range since the end of Q1. We are now, today on the Bloomberg Barclay's index, at 91 basis points. That is the high point to the 11 basis point range. So we have had some under performance, but still from a broad level, spreads remained pretty narrow here.

Dan Krieter:
And even after a losing streak of two weeks up until yesterday, spreads to not move narrower on the index for two consecutive weeks, we're still within that range. So I guess the question is, is this just a bit of a technically driven blip on the radar where spreads just naturally move wider in response to very heavy supply or is it in line with what we've been talking about in the podcast and our written work for the past few weeks, an expectation of a move to a slightly higher trading plateau and credit spreads into the end of the year and into 2022, just reflecting more risk factors out there and less accommodation from both monetary and fiscal authorities going forward.

Dan Krieter:
I mean, I still think it's the latter on that, but maybe to start our conversation today with can look at spreads through the same lens we typically do. We like to look at spreads from three different vantage points. Technicals, macro outlook, and as well as fundamentals. And I think you could look at all three of those and say that the near term path, according to all three, might be for further widening. So I think just given the supply, we've talked about so far today, technicals is a good place to start the conversation. You already sort of, you talked about how despite maybe a less than supportive environment for corporate supply, bonds keep coming to market. And I think you hit the nail right on the head that there is this desire to place debt. Now ahead of what's shaping up to be a pretty important FOMC meeting with uncertainty regarding the path of interest rates going forward. So issuers will hit the market where they can. Now this week it's not really shaping up that way.

Dan Belton:
Yeah. So expectations for supply this week were 8 billion, which is pretty strong actually for Thanksgiving week. It would be the heaviest week since 2014. And we obviously haven't gotten that through the first couple days. I think President Biden's announcement of Chair Powell's reappointment took some wind out of the sales of potential deals announced yesterday, just given the move higher in rates. But it does seem like expectations are for next week to continue to be heavy. I mentioned last week's 56 and a half billion's unseasonably heavy for November. So there does seem to be this rush. And I think that's only going to be exacerbated by some comments from fed officials that we'll probably talk about in the next section of this podcast. Typically, we only see about 42 billion price after Thanksgiving in the year. I think we'll get more than that this year. Just given how much of a rush there seems to be, how much momentum there is in primary markets.

Dan Krieter:
Yeah. And so I think we can just kind of throw this week away. We are seeing evidence of fatigue on the buy side. What little supply has come this week has seen even weaker demand metrics and what you talked about at the top, like you don't want to make too much out of just a couple deals. But clearly we have some fatigue on the buy side. It's thinner staff, just naturally given the holiday week. So the fact that this week's going to fall short of expectation does nothing to change our expectation that we're going to see heavy supply between Thanksgiving and the unofficial end of the year, following the December FOMC meeting. And it may not be a supportive environment for that supply. I guess we can sort of shift the conversation now to the macro side of things. And if we're going to talk about macro, I think the conversation really has to center around the December FOMC meeting. It's certainly the largest event left on the calendar this year and could end up being one of the more important Fed meetings in both recent memory and going forward.

Dan Belton:
Yeah. So I think it's been made a lot more important given recent comments from Fed officials about the potential for speeding up this pace of tapering. We had Richard Clarita on the tape on Friday mentioning that it might be appropriate at the December meeting to reconsider the pace of asset purchases. Since then we've had other regional Fed presidents saying the same type of thing. So there is a possibility that the Fed's going to accelerate its pace of tapering of asset purchases. I think we'd need to see some more guidance on that front, over the next two weeks. The blackout period begins in about a week and a half. So the Fed would have ostensibly next week to really start to message that more strongly. I don't think it's in the base case that the Fed is going to accelerate the pace of tapering at the December meeting, but it certainly is possible. It just would require some more guidance, I think.

Dan Krieter:
Yeah. We're obviously going to have the November job report by then as well, which could further inform expectations further that the Fed will move to accelerate tapering. Personally, this is not something I was expecting at all. I would've given it like a 0% probability as recently as two weeks ago, but clearly that's not correct. There is some chance that this is going to happen. And, you know, whether or not it actually does hard to say I still lean. No, but looking at the December FOMC meeting sort of holistically for credit spreads, it's really hard to paint a picture where risk is going to perform well coming out of that meeting. I mean, you have really a binary outcome regarding the tapering of asset purchases. If they do accelerate tapering, I think the feed through and spreads is pretty clear. That's going to be risk off.

Dan Krieter:
I mean, a hawkish Fed moving against inflation. That's certainly going to pull forward more expectations for rate hikes and it's a clear credit negative. But now let's even assume that the Fed sticks to its transitory guns here. Doesn't adjust the tapering pace for now and continues to insist that inflation will sort of drop on its own. Well, in that case, I would think we would expect to see break evens moving higher and more fear that the Fed is behind the inflation curve, which would also not really be good for spreads. Dan, paint me a picture for a December FOMC that is met with spread narrowing.

Dan Belton:
Yeah, it's tough. It's definitely a double edged sword here. I think like you said, the Fed could come off as risking its credibility or potentially expectations of the Fed making a policy error could increase given a two dovish statement at the December FOMC. So I think really, they would have to do something similar to what they did in November, which is a sort of dovish hold again. Where they come out and they acknowledge the elevated inflation risks, they continue to put a date out there for next year saying that we think inflationary pressures are going to dissipate sometime in the first half of next year, in the second quarter of next year. That would allow them to convey to the market that they are watching inflation. And if it does continue to exceed their expectations from a time perspective, then they would start to change their reaction function.

Dan Belton:
But for them to, at the same time, reiterate that the current pace of tapering is what they'll do at least for the next couple months, until there is some further unexpected, upward pressure on inflation. That to me is sort of the narrow, we've talked a lot about the Goldilock scenario with respect to the economic recovery. It's not too different here. They have to kind of thread the needle with respect to the risks to inflation, but maintaining policy on this course that they're on right now.

Dan Krieter:
Yeah. I mean, they could also try to send a message, I guess, through the SEP, we will have dots coming out that could play with their rate hike dots, or even the inflation dots, inflation expectations to sort of try to present a more hawkish stance on inflation without actually changing the pace of asset purchases. But I think high level, what you said is right. They can continue to thread the needle. And even if they do, that to me, represents nothing more than a neutral outcome for risk. It's not going to be a sudden relief rally or something. It would just be more the same range bond trading condition. So even if we take the FOMC meeting in December as a neutral sign for credit, there is still a debt ceiling deadline that we're going to have to be dealing with in early to mid-December. I mean, we all expect that will get taken care of, but it is certainly a risk factor that weighs on the market, at least until there is a permanent solution.

Dan Krieter:
So you have a neutral at best macro outlook, I think for the remainder of the year. Alongside our expectation, the technicals will not be supportive both on the demand side, just given where we are in the year as well as our expectation of heavy supply. And then fundamentals, which we can transition to now is really the third leg of our outlook on spreads. And on the fundamental side, really the story of the year has been that's one of, if not the most important, factor driving credit spread narrowing this year has been fundamentals. Earnings have been pretty much pristine across the board. There's not much we can say other than that. And obviously earnings are expected to say strong going forward. My question to you though is, are earnings peaking here, or in other words, have we seen the strongest of the tailwinds on the fundamental side and going forward, they might start to slow a little bit and so on a stock versus slow basis, if you will here, the tailwind that you're getting from fundamentals may start to cool off and lead to potentially some degree of spread widening.

Dan Belton:
Yeah, I think that certainly is the case here. We're also seeing that in some sense from base effects to the year over year growth in earnings has been astronomical recently that has probably peaked. So we had earnings grow by about 38% from last year in the third quarter. Revenue growth of about 17%. That's certainly going to slow in the next few quarters as the depths of the pandemic roll out of that year over year window. But as you know, the market doesn't price to past earnings, it prices to future earnings. And that's definitely going to moderate here as we move further away from the pandemic. Of course, credit worthiness, some of those metrics remain very strong. Net leverage, this just as of this quarter dipped below levels seen before the pandemic. So net debt to EBIDA fell below three for the median borrower in the IG index.

Dan Belton:
And that's pretty noteworthy just given how much of a run up in leverage we saw at the beginning of the pandemic that we're now below end of 2019 levels. I think that's worth talking about. Interest coverage ratios, given the improvement in earnings and the reduction in interest rates, interest coverage ratios are now the best that we've seen since 2014, 2015. But from an earnings perspective, like you mentioned, some of the analysts revisions are starting to look more moderate than they have been at any point in the past year or so. We're just going to move away from this rapid, rapid growth in our earnings to something more normal like we saw in the years following the financial crisis.

Dan Krieter:
Yeah. You touched on the equity analyst revisions. That's down to post pandemic lows, not low from historical perspective, but the lows we've had in this cycle. We've obviously seen a parade of corporate executives coming out, talking about the potential impact of higher input prices and higher employee costs on the bottom line going forward. And you even talked about the strength of balance sheets. I mean, yes, that's undeniably a good thing, but also arguably paves the way for more issuance, right? That feeds into our projection for more debt going forward is that balance sheets are now healthier. So you could start to see some more investment into the business to try to lever up a little bit and maintain profits. Even if you're going to have a lower profit margin, more leverage, you can keep earnings at least steady. So that does imply to me that, again, another reason things supply will remain heavy. But also looking just more specifically Q3, looking at the drivers of those earnings that were again, undeniably good, but looking a little bit deeper, perhaps they weren't as sustainable going forward.

Dan Belton:
Yeah. So with respect to how earnings have performed in this high inflationary environment, we looked at the development in corporate profit margins and we saw that profit margins were actually little changed year to date. They are maybe modestly improved at the index level. We have seen a notable improvement in operating margins, which tend to generally move fairly closely in line with profit margins. But this divergence we've seen in operating margins, outperforming profit margins, when we really dig a little bit deeper into that, we see that the cause for improvement in operating margins is due primarily to a reduction in other operating expenses, which is really more of a one off feature in corporate earnings, not something that reflects say, an increased in efficiency that's going to be sustained on a longer term basis. But it's really due to pandemic related and other unrelated things such as MNA and other write offs of losses.

Dan Belton:
Things that we don't think are sources of sustainable gains in operating margins. So it'll be interesting to see how that evolves in the next couple quarters, but I think there's reason to expect that operating margins, even though they've seen a temporary boost this year, they should come back down more in line with where profit margins are. Which is little change this year, amidst the high inflation. But then if we do see a reduction in consumer sentiment or reduction in just the strength of the consumer, it might become harder for corporations to pass through these higher prices to the consumer.

Dan Krieter:
Yeah. So just to put a bottom line on it, again, we're not saying that earnings are going to drop drastically from here, but there is a pretty compelling argument supported by what you just talked about with savings on the expense side that may not be sustainable into the future. That earnings and earnings momentum may have actually peaked here in the third quarter. So going forward, earnings may not be as strong a tail when you combine that with a neutral or negative outlook on the macro side of things and undeniably negative technicals. And you still have a pretty bearish view on credit spreads, at least between now and the end of the year, especially with the huge supply of January looming. So I wouldn't be surprised to see spreads continuing just to leak wider here in the course of the next couple weeks, when supply does return post Thanksgiving and meets tepid demand. You know, I'm not talking about a major widening in credit spreads, anything not orderly, but getting close to the hundred basis point level in early 2022 certainly seems doable to me.

Dan Belton:
Yeah. And that's where we were at the beginning of the year. I think spreads year to date have been in this 80 basis points to 100 basis points range. I do think that's going to hold through the year, but I wouldn't be surprised to see us get up to about 95 basis points or so by the end of the year.

Dan Krieter:
And the risk to that might even be wider. I mean, if the Fed comes out and actually adjust its pace of tapering, I think you could see a more volatile move in credit spreads. Because that is confirmation that the fed is not going to be as patient regarding inflation as maybe we thought, or maybe they've implied so far. And I think there is no sugar coating that for credit spreads. I think they have to widen if we're going to really see the Fed take that step and really meaningfully pull forward expectations for the path of liftoff.

Dan Belton:
Yeah. And it seems like there's a lot of credit investors who are on the same page as us, and they've been wary of adding positions for the past couple months. Now, given these valuations, given high inflation and a potential for the Fed to maybe move quicker than the market had been pricing, it's possible that we're going to see that play out.

Dan Krieter:
Okay. Well, I think Dan, with what time we have remaining on the podcast today, I wanted to at least touch on the move and swap spreads. Particularly short under the curve because it has been pretty dramatic here over the past month. We've seen short end spreads, we'll just say a two year spreads here, widen around 17 basis points are so volatile. I think today spreads are in like three basis points. So there's a lot more volatility, but generally short end spreads in the two year sector, 17 basis points wide are talking about LIBOR swap spreads here. And I just want to talk about some of that move and what's really driving it. So I guess the place to start with our discussion on LIBOR swap spreads is just the cost of funding component of it. Because we've seen some widening in the [inaudible 00:16:58] complex over the past month.

Dan Krieter:
I think the drivers there are pretty clear, just a more hawkish Fed. We've talked about increased regulation in our previous episodes. Brainard obviously isn't going to be the new vice chair supervision. She took the vice chair, the federal reserve, or else we don't know who the vice chair supervision's going to be. But the expectations, it will be someone pretty hawkish on the regulatory front. I mean, Brainard is still on the board in a very influential position. So I think the path of regulation is going to be undeniably more hawkish, which has led to widening the [inaudible 00:17:29] complex. So a couple factors there, but when you look at what the widen in [inaudible 00:17:35] has meant for the fair value of two year LIBOR swap spreads, the [inaudible 00:17:39] widening has been worth about seven basis points, five to seven basis points out of 17. So that leaves us with more than half being attributable to something else.

Dan Krieter:
And that's something else, if we look a little closer has been a somewhat eye opening move in SOFR swap spreads. Looking now again, just at the two year sector. SOFR swap spreads are nine to 10 basis points wider over the course of the past four to six weeks. And that's something that's really sort of surprising given what SOFR swap spreads are. I mean, they're really sort of just a Treasury OIS measure right now with the measure of demand for Treasuries. And we've seen that widen 10 basis points. Maybe that's a bit counterintuitive as we're seeing things like weak auction statistics coming in, all these reports of the short base, and even specials in the two year sector in October. It seems like there's a lot of people short. So how do we reconcile that view with 10 basis points widening and SOFR swap spreads, which seems to imply heavy demand for treasuries.

Dan Belton:
Yeah. And we've seen a similar move in Treasury OIS, I guess when you're looking at it, optically it's the reverse move, but Treasuries are moving richer to the short rate complex, I guess. And like you said, it's a little bit counterintuitive just given that it seems optically, like there is a weakness in demand for Treasuries. You've had the front end really get crushed over the past couple of months, but as rates move higher, there is still a strong bid for short end Treasury paper. And I think that's been particularly true for all in yield buyers as the US rates complex moves higher, particularly given foreign alternatives. And then even if you look at credit, credit spreads are very rich. Equity prices are near all time highs. Short end Treasuries are not unattractive product here. And I think that's been an important reason for this widening in front end swap spreads.

Dan Krieter:
Yeah. I think you hit the nail on the head there. If we're dealing with an environment that maybe doesn't look very supportive from a macro perspective, particularly with inflationary concerns, raging, where do you want to be right now, if you're a fixed income investor, do you want to be in 10 year Treasuries? I mean, given how flat the curve is that could theoretically steepen out. If inflation's going to take off here.

Dan Krieter:
It's not what we're expecting, but you know, real yields in the 10 year sector and the long end in general are just so low right now. And you've had this backup at the short end. Maybe you just want to go into the short end of the curve that gives you some cover if things crack. If credit rolls over, if the market starts to decline you, you've got some potential for all performance there at the short end of the curve, as those rate hikes price out. It's just, we've heard the euphemism Tina many times in stocks. Well, in the fixed income market maybe Tina applies a bit to the short end of the curve here. So the next question really becomes for the spread aspect of things. When can we expect this to change?

Dan Belton:
Well, I think we've seen some of that already happening this morning. It's unclear if that narrowing is going to be sustainable, but I think we are starting to reach some pretty extreme levels. So two year SOFR swap spreads touched as high as six basis points yesterday. They're in about four basis points today, but you know, that spread should remain theoretically fairly close to zero, if not negative. I mean it was negative 10 basis points a year ago. So I think as we get to these extreme levels, I don't expect that to persist for too long. Yeah.

Dan Krieter:
Looking at the historical chart of SOFR swaps, and actually before 2019, they have to be sort of indicative, obviously SOFR didn't exist then. So it's pretty much just a fed funds proxy used for SOFR going that far back. But looking at the chart, there are two things that really stand out. First, we are at an outsized move here. Being positive four to six basis points, like you said yesterday, is about as high as they've ever gotten. And the second thing that jumps out is we tend to see widening in this basis at this point in the cycle. So you look back at 2014, the last time spreads got this wide was 2014 and early 2017. We had the Fed normalizing after QE# in 2014 and we saw SOFR swap spreads get this wide again. And then in 2017, post money market reform, we saw SOFR swap spreads wide in into positive territory.

Dan Krieter:
So this has happened before at times that are at least roughly similar to this. So it's not overly surprising from that vantage point, but you're near the all time highs in the last 10 years. Actually, you're pretty much at arbitrage levels here. I mean, positive SOFR swap spreads is... It's not the most profitable trade of all times. I don't think people are going to be like putting this on in massive volume. But it's almost arbitrage profit now for a of SOFR swap spread. And so I'm with you. I think we are maybe getting to the point where swap spreads are reaching local highs. I don't know that I think that we're going to see a sudden collapse in swap spreads or front end swap spreads by any stretch of the imagination. I don't think that, but I do think we could be getting to levels here where we're reaching extreme levels.

Dan Krieter:
I think year end may be playing at least a minor part in this to disappear of balance sheet, the end of the year. Particularly we just had two year Treasuries trading, super, super special in repo. I think that there are some year end mechanics here that could be playing a role. So coming into the new year, once year end balance sheet concerns, even though they're lower this year, they're still there. Once they're gone, I think you could start to see some relief at the short end there.

Dan Krieter:
So I think now wouldn't be a terrible time to try to take advantage of that. If that's going to be swap spread narrowers at the front end of the curve, or maybe steepeners, or even just looking at carry trades, maybe at the short end, that would benefit from some moves lower in both SOFR and LIBOR swap spreads. I don't hate that now, or at least in the future weeks going forward for any trades you are going to do looking at the current level of swap spreads as maybe sort of as high as we're going to get here for the time being. Anything I missed. Dan?

Dan Belton:
No, I think that covers it. Thanks for listening.

Dan Krieter:
Have a very happy Thanksgiving, everybody.

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 a FICC macro strategy group in BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:
This podcast has been repaired with the assistance of employees of Bank of Montreal. BMO [inaudible 00:23:44] 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 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 here in may be suitable for you.

Speaker 2:
It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment legal accounting, or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances or otherwise it constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures, contracts, and commodity options or any other activity, which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the us commodity exchange act. BMO is not undertaking to act as a swap advisor to you or in your best interest in you to the extent applicable, you'll rely solely on advice from your qualified independent representative in making hedging or trading decisions. This podcast does not be relied upon in substitution for the exercise of independent judgment.

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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