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The Waiting Game - High Quality Credit Spreads

FICC Podcasts 13 avril 2022
FICC Podcasts 13 avril 2022


Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the recent volatility in credit spreads, and the likely near-term path looking ahead. Finally, they conclude with a discussion on supply technicals in both IG and SSA markets.


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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. This the week of April 13th: The Waiting Game. I'm your host, Dan Krieter, here with Dan Belton as we discuss the recent volatility in credit spreads and where we expect they'll go in the weeks ahead. Finally, we conclude with the discussion on technicals in both IG and SSA markets and how technicals might influence the path to spreads.

Dan Krieter:

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@bmo.com. We value and greatly appreciate your input.

Speaker 1:

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

Dan Krieter:

Well, then, believe it or not, I think it's been close to a month since our last episode of Macro Horizons: High Quality Spreads due to a combination of vacations and Macro Monthlies and business travel has returned full force now. So we have a lot to get caught up on. Why don't we just start with a quick overview on what credit's done in the past month?

Dan Belton:

Yeah, so it's really all been about this volatility and credit for the past couple of months. After gaping wider for most of the early part of March, spreads peaked in the middle of last month. And then I think the most surprising price action and credit spreads has been that they really screamed back narrower from their peaks in the middle of last month, moving about 30 basis points narrower in just three weeks. It's been a historical period of volatility. Only a couple times in history have we seen the daily volatility and total returns and excess returns greater than we saw over most of March, and a lot of that is attributable to the degree of narrowing. I think that is the most important thing that's happened in credit markets. Once funding conditions really firmed, and that happened in early to mid-March, that's when investors started to pile back into credit. And we were expecting, once funding conditions sided, we were expecting credit spreads to narrow slightly from their peaks, but the degree of narrowing was certainly a surprise to us.

Dan Krieter:

Yeah. I think starting with the discussion on the rally is probably the most important thing here, because, as you said, there were a few notable characteristics of it. I mean, it was a 30 basis point move narrower in a three week span that had only happened two other times in the past decade, and, perhaps more importantly, we'd never seen a move of this nature with spreads at already so low a plateau. We're typically used to seeing spreads narrow significantly when they're coming off of stress environments like the pandemic or financial crisis or even European debt crisis, things like that. This didn't really happen. I mean, we had a significant move wider earlier in the year, but we were still tapped out at like 150 basis points, historically not a very elevated level, and we rallied 30 basis points from there. So I think it's important to look at the drivers of it.

Dan Krieter:

You talked about funding conditions. I certainly agree. That was most likely the largest driver, is some of the fear around the financial sector regarding Russia, Ukraine and the unknown impact of sanctions sort of started to fade. But I guess I'll put the question too, we maintain a model on credit spreads, and a model is a model with the known shortcomings that models contain. But it's still a valuable tool to have. So what has the model been telling you regarding the drivers of the narrowing?

Dan Belton:

Yeah, Dan, it's interesting. When we look at our model for high grade credit spreads, like you said, credit spreads narrowed about 30 basis points on a week over week basis over the course of three weeks. Our model was only able to explain about 10 basis points or one third of that narrowing. And, actually, all of that narrowing, our model attributes to an improvement in financial conditions. And so in our model for financial conditions, we use the V of A Global Financial Stress Index or GFSI. And there's a lot of different financial condition indexes that you can use and they'll tell you different things, so I think it might be worth talking for a minute about these financial conditions indexes and what they tell you and why we use the Global Financial Stress Index.

Dan Belton:

If you look at another index such as the GSUS Financial Conditions Index, that actually shows financial conditions as currently more accommodative than at any point during the 2010 to 2019 business cycle expansion. And I think that's probably because it gives a high weight to the amount of liquidity in the system. But we prefer a faster-moving measure of financial conditions, which is why we usually use the GFSI. I think most market participants would now view market tone is pretty tenuous right now. So I don't think a measure showing very accommodated financial conditions is really true to the spirit of what we're seeing in the market right now. And so even the GFSI, though it's showing financial conditions as somewhat stressed right now, they're well off their peaks of market stress that we saw in the middle of last month. And that's what drove most of the model-implied narrowing, but it still leaves about two thirds of the narrowing in credit spreads as unexplained and likely due to just a technical component of the move driven by really strong demand.

Dan Krieter:

Well, it's actually worth noting that the calming in financial markets captured by the Financial Stress Index explained more than 10 basis points in narrowing. I think it was as much as 25 basis points in narrowing from peak to trough in terms of financial stress, but we only got to a net of 10 basis point narrowing because we saw other variables that should have been causing some widening pressures, most specifically, the rapid repricing higher Treasury yields over the past month, as well as a continued decline in analyst expectations for earnings looking ahead that combined put significant widening pressure on credit spreads. So it wasn't necessarily just credit outperforming during a calming of markets, but it was also credit outperforming despite other variables indicating widening pressure, which I think just goes to support what you said earlier, which is that it does seem like there was a technical component of the recent rally. And I want to spend a minute breaking those down.

Dan Krieter:

But I think high level, I'm just calling this the FOMO rally in spreads really. I think this was just spreads got to a level we haven't seen in years. And we know the Q1 is typically a time when a lot of trades are implemented. And if you really look at market conditions, from the first of the year, there really wasn't a great time to put money to work. I mean, it had been a pretty much a straight line wider in credit spreads amid volatile markets for most of the year. Then we do get a bit of calm, things start to normalize a little bit. And you look at where both outright yields and spreads are and it's like, okay, well, it starts to a little bit. And I think there was a big component that, Hey, I don't want to miss my chance here to put some money to work at wider spread.

Dan Krieter:

So I think, and Dan, I want you to talk a bit about some particular type of investors in more detail, but high level, I just think there was a lot of money to be put to work and people not wanting to miss these spreads. We should also mention rebalancing flows as potentially another large technical driver here. Just after the first quarter performance in fixed income, I think there was a pretty heavy contingent of rebalancing flows into corporate bonds. And we know that obviously corporates trade with a fair degree of momentum, it is observable historically, momentum, and rebalancing flows would have certainly put the momentum toward the narrowing side. And when you think about it from a rebalancing standpoint and just how attractive corporate bonds were to a few different types of investors, a technical component makes sense.

Dan Belton:

Yeah. I think you hit the nail on the head there talking about the backup in spreads and investors seeing more attractive all-in spread levels in the middle of March than we've seen, really excluding the pandemic, just about as attractive as they've been since 2016. But I think taking it a step further, if we look at the backup in all-in yields, just given the outright sell off in Treasury yields, corporate bond yields trading at around 4% right now at the index level are currently higher than they've been for most of the last decade, excluding a short period at the end of 2018 and beginning of 2019. And there's been investors who have been not sitting on the sidelines entirely, but bemoaning some of these low yields and tight spreads that we saw for most of 2021, and now you get this backup where there's yield levels that are twice as high as we saw for a lot of 2021. And that has really enticed a lot of buying.

Dan Belton:

And then specifically we have currency hedge returns for Japanese investors for the high grade bond index are the most attractive that they've been at any point since about 2016 and hedging costs are set to rise alongside the increased Fed rate hikes that are priced in for the rest of this year. But it's likely that all-in yields are more important of a gauge for foreign demand. And assuming that this selloff in yields doesn't really reverse, these higher all-in yields are likely to remain and foreign demand is likely to continue to play a strong role in 2022.

Dan Belton:

And then the second buyer group that I think is seeing attractiveness in US dollar corporates right now is pension funds. So Milliman estimates that the largest 100 US pension funds are currently overfunded for the first time since the financial crisis. And typically, as pension funds see an improvement in their funding status, they typically rotate into fixed income and out of equities. You can think of it as, instead of chasing higher returns to sort of improve their funded status, they can lock in a better funded status by investing in fixed income and in specifically US dollar corporate bonds. And so this should pose a significant tailwind for credit as well from pension funds.

Dan Krieter:

We've spent a few minutes now talking about the technical components of the rally. I think that the case there is pretty strong, and I've seen spreads go the other way here a little bit in just the past week. And I think I want to back up a bit and just look at now spreads, what do we expect for the future? And how does this fit with our high level view on the market? Because I think this sort of playing out the way we already thought it would at the beginning of the year, like we came into the year expecting a significant move wider during the first quarter of the year, which we ultimately got. And then we had the view that spreads would enter a range bound type of environment in Q2 while the market awaited incoming economic data, specifically inflation and consumption data, and we needed to see that data to judge the health of the economy and what would ultimately be the next move in spreads at that point.

Dan Krieter:

I think what we've seen is the market sort of fitting into that view. I think we'll admit readily that the range now in the past month has maybe been a bit wider than we expected, just given volatility, but we've seen the upper end and the lower bond probably established now. And we see some further consolidation. Probably a smaller trading range would be established in the weeks ahead while we continue to weight that data. So I still personally hold the view that we'll be range bound now, and the question becomes, once that range is broken, what direction will it break? And to try to answer that question, I guess we could start by saying, what are some of the factors you're looking for that will determine the next move in credit?

Dan Belton:

Yeah, I do think we're going to be range-bound here for the medium term, at least until there's more macro clarity that will inform the next direction of credit spreads. And I think whether we break out to the narrower or wider end, we'll probably come down to two things, and I'm thinking of the strength of the consumer and also whether the Fed is able to engineer a soft landing. And those two things are very interrelated. So the market's now pricing for another eight rate hikes for the balance of 2022, and that's going to put a strain on not just the consumer, but probably corporate profitability as well. And our regular readers and listeners will know that we've been watching profit margins as inflation has continued to come in stubbornly high and profit margins have been compressed over the past few quarters. And that's going to be an extremely important factor as Q1 earnings are released over the next several weeks.

Dan Belton:

We're expecting more compression and profit margins in Q1, just given how elevated inflation has been, particularly given the food and energy component of this elevated inflation. And then there's reason to expect the consumer might come under some more pressure later on this year. We've been tracking the savings rate as a potential barometer of the consumer going through some of the pent up savings that were accumulated over the pandemic. And the savings rate has declined this year to levels last seen in 2013, 2014, and that's likely to put upward pressure on the labor force participation rate, which might alleviate some of the upward pressure on wages, and wages to this point have already struggled to keep up with rising prices more generally. So none of these paint an especially bullish picture for consumption later this year. But again, we're not likely to have clarity on this until later on in the year at the earliest.

Dan Belton:

And I'll wrap up with JP Morgan's earnings this morning. JP Morgan was the first US bank to report Q1 earnings, and saw decent results overall, but some negative components that I think the market really was paying attention to, most notably, the increase in provisions for losses that JP Morgan set aside citing higher probabilities of downside risks. So when the largest US bank is emphasizing the probabilities of downside risk from a macro perspective, I think the market is listening to that.

Dan Krieter:

Yeah, I think that's a great summary for some of the concerns surrounding growth in the mindset. I mean, all year we've closely tracked the path of consumption. Because we came into the year with this idea that pandemic-driven savings could be exhausted around the mid point of year, which we're now approaching. And consumption data has certainly not been bad all year, but there has been some cracks that have been starting to become observable in some of the leading indicators. And I think that the best way to say it is there's risk out there of the consumer potentially weakening, and given headline inflation that isn't slowing down anytime soon, corporate's having a very hard time passing along the increased costs of inputs along to a consumer, and that can be a quasi-static inflationary environment, but certainly one that's not supportive for corporate fundamentals, which would send spreads much wider.

Dan Krieter:

Now, this may end up not happening. Maybe the consumer will stay strong throughout the whole cycle and profits will stay strong and spreads stay range-bound at still relatively narrow levels. But I think the key point is there is significant risk out there and I don't think that investors are being compensated for the risk at this point. Just look at the relative value proposition of credit spreads right now. The broad IG index is now adding around 42, 44% yield enhancement over the 10-year Treasury, which is actually the lowest since the pandemic. Despite the very, very narrow headline spreads for all of 2021, your yield enhancement from a percentage standpoint is actually higher then than it is right now.

Dan Krieter:

And broadening that historical look to include more data historically, since the financial crisis, there've only been four environments will where current yield enhancement levels were sustained. And I would say all four of them ... Well, first, none were significantly tighter than now and all four of those environments would be characterized as a yield grab type of environment when market participants thought rates would settle forever, inflation was dead, and it was just all about yield enhancement driving very narrow spreads. That couldn't be than the environment we're in right now.

Dan Krieter:

So whether or not the consumer ultimately weakens and profits deteriorate, blah, blah, blah, blah, there's a chance for it and just current spreads aren't giving us that. So from where I sit now, I think that another leg wider in credit is the most likely outcome. But just given the fact that we're going to need more economic data before that really trades, we're going to see most likely range-bound conditions in the inner term, and in a range-bound type of environment, I think technicals play a very important role. So I'd like to transition now just to talk a bit about technicals. We'll start with you, Dan, in the IG space. How would you characterize market technicals in the past month or so? And what's the outlook?

Dan Belton:

Well, supply can 10 years to come in, very heavy in the corporate market. In March, we had 233 billion in gross issuance. That's the fourth heaviest month on record, really behind only March, April, and May of 2020. So excluding the extraordinary period of the onset of the pandemic, last month was really the heaviest month of supply we've seen on record. And as for the reasons for that, there's a few, and some of them are more technical and others more fundamental. First, the market volatility and geopolitical uncertainty that we saw throughout February probably pushed some issuance back into March. So just a technical reason there.

Dan Belton:

And then, second, more of a macro narrative here. We've heard a lot of issuers anecdotally pulling forward issuance from later on this year forward into March, just given the expectation for Fed rate hikes and this selloff in Treasury yields that really seems to be unending here. And just to put some numbers in to add perspective to that, corporate bond yields at the index level sold off 50 basis points in March. So even though concessions were elevated, accepting a 10 or 20 basis points of concession really ended up paying off for issuers who pulled forward issuance and got their supply in the market before the rates kept selling off. So the higher rates, I think somewhat ironically, have caused issuance to be heavy in March. Then we've had elevated M&A financing and spinoff financing as well as continued heavy financial supply.

Dan Belton:

Now, while higher rates might have been a tailwind for March supply, I think there's reason to expect it might end up coming out of later in the year supply. So there's definitely downside risk now to supply in the second half of this year, given higher rates and also the faster-than-anticipated quantitative tightening that the Fed is set to unroll next month. I think that could weigh on specifically financial supply as the Fed starts to reduce the size of its balance sheet.

Dan Belton:

Now, the last thing I want to touch on in the high grade technical space is new issue concession and new deal reception. In nine of the past 10 weeks, average new issue concessions have been 10 basis points or higher, which we've really only seen once before, which was in the spring of 2020. Two weeks ago, we saw concessions drop to five basis points on average, but then since then they've climbed higher and we've seen increased evidence of investors really being a little bit pickier about pricing or a lot more price-sensitive in recent weeks. We've seen a lot of drops in order books as deals have tightened from IPTs to the eventual pricing level. And I think that's something that's important to keep an eye on and it's going to really dictate how much more supply this market is going to be able to handle.

Dan Krieter:

And then quickly, I just want to finish by talking about some SSA market technicals, because really SSA performance in the first quarter of the year has been pretty remarkable. Despite a significant widening in IG spreads, SSAs were maybe five or six wider at their worst all year. And I think a big part of that was because of very supportive technicals in the market. In fact, net US dollar SSA supply during the first quarter was the second lightest of any quarter we have on record. And that's particularly notable because it came in the quarter, where we typically expect very heavy SSA supply. In fact, this was the only first quarter we've ever seen that was negative in terms of net USD SSA issuance.

Dan Krieter:

And now, the drivers behind that are obvious, but it gets to a point now where borrowers are running a bit behind in terms of their funding progress for the year. I mean, it's certainly nothing that we're sounding any alarm bells over or anything like that. There's still plenty of time when they're not that far behind the pace in years past. But it does mean that going forward, SSA borrowers could be a little more active, and that's particularly true if we start to see some expansion of borrowing this year to fund any support for Ukraine and refugees, things of that nature.

Dan Krieter:

So I do think we'll see SSA issuance start to pick up in the months ahead, in the very near term, in fact, because May 31 is somewhat of a defacto ... I don't want to say deadline, but unofficial deadline before the summer months get here and issuance dries up. So if that's the case, cross-currency bases are indicating dollar is an attractive funding currency, both domestically and foreign issuers as well. So when that supply does pick up, I think obviously the technical picture will deteriorate, and that could put some upward pressure on SSA spreads that have outperformed significantly this year. And we have seen a little bit of upward pressure on credit spreads in SSAs in the last week or so. Not much. There may be leaking two, three wider. But I do think that's the start of something that could be a slightly larger move as the technical picture deteriorates.

Dan Krieter:

Well, Dan, looking at the recorder, I think we have definitely used up enough of the audience's time here today. Have a great long weekend, 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 the FICC Macro Strategy Group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

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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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