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Defensiveness at a Discount - High Quality Credit Spreads

FICC Podcasts June 22, 2022
FICC Podcasts June 22, 2022

 

Dan Krieter and Dan Belton discuss the recent performance in credit, including why defensive sectors have not performed as well as they typically do during selloffs. Other topics include the recent decline in SOFR and when the downward pressure on the new benchmark might normalize.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello, and welcome to Macro Horizons: High Quality Spreads, for the week of June 22nd. Defensiveness at a Discount. I'm your host, Dan Krieter, here with Dan Belton. As we discuss recent trends in credit markets, including under-performance in traditionally lower beta sectors during 2022s widening thus far. Finally, we conclude with the discussion on SOFR, which continues to print well through the Fed's RRP rate.

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, K-R-I-E-T-E-R@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, it's good to be back here on the Macro Horizons, High Quality Spreads Podcast. Obviously, we were back last week with a reaction to the Fed episode, but our first normal episode, I guess you could say in a long time. Now after a six week hiatus. And obviously, a lot's happened in those six, seven weeks here. So I'm not totally sure where to start, I guess maybe we could start with, why don't you talk a bit about how spreads have unfolded as it pertains to our view on credit in 2022, from a high level in the past six weeks, just to sort of reset here in the High Quality Spreads Podcast.

Dan Belton:

Yeah, so we had been looking for credit spreads to trade range bound for most of Q2, and then ultimately moving wider. And that view has largely come to pass. So, after hitting their wides of the year in March, credit spreads had a few bouts of narrowing and exhibited really elevated volatility. And they've drifted a little bit wider in recent weeks.

Dan Belton:

And we now expect credit spreads to start to move wider, breaching the year to date highs, which were only about five basis points inside of, at this point. And it's really the macro view that we're expecting to drive spreads wider. It's the inflation outlook, it's the recession fears that have been really elevated in the past couple weeks, just judging off of the market discourse. And it's tighter financial conditions, which we've really only started to see the beginning of the Fed's rate hiking cycle. And that's going to continue to weigh on asset evaluations.

Dan Krieter:

Yeah. So, you said it, we're about five beeps from the year to date highs and spreads, that 150 basis point level, more or less holding twice. I think maybe it was printed above by one or two beeps a day or two. But that 150 level, more or less holding all year, so far. And so, in the near term, trying to decide if that level's going to hold again.

Dan Krieter:

And I'm with you, that I think that we are now going to see a move to a new plateau on credit spreads, that we're going to breach that 150 level and move higher. And I think that views based off of really three factors. And I think we should talk about all three of them in a little bit more detail. And the first one is just, I think we have to talk about is, the technical factor, where I think you can make a fairly compelling argument that technicals, at least from a data perspective, are nearly the worst on record.

Dan Krieter:

And we can start with the supply side here. Where, until yesterday, the primary IG market was shut for seven consecutive business days. Now, that's a little misleading since we had two Fridays and a Fed Wednesday in there. So really, maybe only four true quote-unquote "goose eggs" in there. But even with that caveat, I mean seven consecutive business days with no IG supply is exceedingly rare.

Dan Krieter:

Looking back through the financial crisis, we can really only find two other instances where this happened. The first one was alongside the financial crisis immediately following the collapse of Lehman Brothers. And there was another episode in 2015 alongside slowing growth fears out of developing Asian economies where we saw another shutdown in the IG market. So this is really only the third time this has happened. And then you combine that with the picture on the demand side and it's even more dire.

Dan Belton:

Yeah, we've had fund outflows that are near record highs in the IG space. Last Thursday LIBOR reported the third largest weekly outflow from IG funds behind only two weeks in March of 2020. And we've also had 12 consecutive weeks of net outflows from IG, which is the largest on record.

Dan Belton:

And then to add another point on the supply front, it's not like supply technicals were very rosy for much of the year before markets were shut. And we had about five months of double digit new shooting sessions on average, which is also an unprecedented period of poor reception for new supply. So, really anywhere you look in the technical space, it's not looking very bullish for credit right now.

Dan Krieter:

And we got some new issuance yesterday. I wouldn't say it's much you can read a significant amount into, I think we had an energy deal, which energy has been in consistent out performer all year. So, the deal performance went relatively well, but I don't think it's anything we can make a big deal out of, particularly with the Oracle Deal looming, potentially going to be announced any day now.

Dan Krieter:

And actually, I think perhaps the most important takeaway in yesterday's primary session was in the SSA sector where we had four new issues from US dollar SSA borrowers, the first in two weeks. And SSA sector typically higher quality, you get lower concessions. All four of them printed with upper single digits in the eight basis point range for new issue concessions.

Dan Krieter:

And that may not sound like a lot in the context of what we've seen in the IG market these past few weeks and months, but SSAs, like I said, typically you get much less concessions, like I'd say zero to two basis points in quote unquote normal times is what you get in concession in SSAs. And we're talking around eight. So, an argument for quadruple what's normal in the SSA market.

Dan Krieter:

So, extrapolating what we saw in SAS yesterday to the IG market and a big jumbo deal coming combined with all the demand side headwinds you talked about, it doesn't seem to be a very supportive picture, even on the technical front for credit spreads going forward. And then you combine that with the other two factors driving our view for credit to move to a higher trading plateau. The second one of them is simply the path of monetary policy. We talked about this at length in our podcast last week, where we reacted to the Fed's June meeting. I recommend going back and listening to that from more detail. So, we won't spend too much time here, but I think two big things worth mentioning, again, that stood out from the Fed's June meeting.

Dan Krieter:

The first one for me is the Fed's clarification that they're going to be fighting headline inflation and not core. And that's so important for me because built into our meeting term view was the expectation that the Fed would eventually take a dovish or more dovish turn and start to highlight the role that central banks play in fighting core inflation while admitting explicitly or not that they didn't really have much control over headline inflation or factors of headline inflation oil and food prices given supply shocks there.

Dan Krieter:

But the chair clarified that headline inflation is what they're fighting. He gave a very compelling reason for why that is. And to me, that says the Fed's going to remain hawkish potentially longer than we thought originally in our 2002 outlook. So, that was one. And the other one was just the chair's characterization of the economy, which dovetails into the third factor, driving our bear issue on credit here. And that is just recession odds are rising.

Dan Belton:

Yeah, last week's FOMC there was a lot more pessimism about the state of the economy. Back in the past couple meetings, Powell had been really optimistic about the odds of a soft landing saying that the economy was well positioned to withstand the rate hikes that the Fed was poised to deliver in March. I think he even said the economy would flourish amidst these rate hikes, and then last Wednesday, it was really more of a tone of "We'll see, I think it's still possible to achieve a soft landing, but it's going to come down to factors that are ultimately outside of our control."

Dan Belton:

So, a lot more of a realistic and pessimistic view from the chair. And I think the market took that in stride. And that's why we've seen some real weakness in risk assets last week. And that's against the backdrop of data that's really been turning over. I mean, Q1, we obviously saw the negative real GDP print and then Q2, the Atlanta Fed GDP now is tracking roughly flat GDP growth, which is tracking about 0% GDP growth, which implies that the odds of at least a technical recession in the first half of this year are close to 50%.

Dan Belton:

We've had retail sales and housing market data disappoint recently. The university of Michigan consumer sentiment number two weeks ago was the worst on record. We're looking for the leading economic indicators on Friday to drop by 0.4% month over month. So really anywhere you look, the data has unfolded in a negative fashion and we think that's going to continue as long as the Fed continues, its trade hiking cycle. And starting in just three weeks again, we're going to have another round of earnings releases and there's going to be a lot of focus on recession odds when we start to hear from the big CEOs.

Dan Krieter:

Yeah, that R word indicator certainly increased recently. It's been very visible to all of us, a lot more chatter on the odds of a recession. It seemingly has transitioned from an if we get a recession to a when a recession comes proposition or feels like that way, at least. And what's most important for me from a credit spread perspective is that I don't think that we've really priced in that recession odds yet.

Dan Krieter:

And it's going to happen in the weeks and months ahead, which is really, probably all we need to know to have an underweight view on credit here. And I'll tell you why I don't think recession odds are meaningly priced any credit spreads yet. And it has to do with the performance of sectors in the widening of 2022 or even all the way back to their lows in September of 2021.

Dan Krieter:

The widening that we've seen has been sort of atypical from a sectoral perspective when compared to the historical spirit since the financial crisis. And to demonstrate this, we went and looked at the absolute widening in every sector of the IG market since September of 2021. What we found was that the widening has been mostly uniform. It's been in a generally tight range where all sectors are between roughly 40 and 70 basis points wider with the exception of one sector.

Dan Krieter:

The leisure sector has underperformed this year, but all other sectors are in a relatively narrow band. And that's not what you'd expect. Looking at the historical relationship between different sectors and risk off environments. Typically, we'd expect a range of closer to 75 or 80 basis points between the best performing sector and the worst performing sector in a widening episode, such as this one. And we got to those numbers by looking at betas between just each individual sector and moves on the broad IG index as a whole.

Dan Krieter:

So very obvious example here, if the broad IG index is 10 basis points wider in a given sector is 15 basis points wider that would give us a beta of 1.5, and we went back and calculated the beta for each sector since the financial crisis and found that we should have a divergence of about 75 basis points between the best and the worst performing sectors. That hasn't happened this time around because the traditionally more defensive, lower beta sectors, have underperformed what we'd expect from beta expectations while traditionally higher beta sectors have outperformed their beta implied widening in 2022.

Dan Belton:

Yeah, I think the most likely explanation for this is that we haven't yet seen the defensiveness rotation take place to this point in the year. And to this point in the underperformance and credit, it's really been a trade based on inflation. And about a year ago, we published a piece about how to invest in an inflationary environment. And we looked at this from a sectoral standpoint.

Dan Belton:

We see a lot of similarities between what's underperformed and overperformed this year and what we expected would do well and poorly in an inflationary environment. So for instance, some of the underperformers relative to what their betas would imply this year have been consumer goods and technology. Those are also two of the sectors that we pegged as poor performers in an inflationary environment.

Dan Belton:

Similar on the other side, energy and basic industry, which typically do well in inflationary environments, those have performed very well this year. And so, we think we're getting to the point where the market is going to start pricing increased odds of a recession, even though it hasn't quite done that yet. And moving from these inflationary sectors into ones that are going to be more defensive and perform relatively well during an economic downturn, I think makes a lot of sense right now.

Dan Krieter:

Yeah. Dan, you said it not only does what we found provide an opportunity to switch out of the best performers issue that are more exposed to energy and commodity prices and into more defensive sectors. But it also implies that just from an absolute level, those recession odds have yet to price into the market. And as they do spreads in general are just going to move wider. So, that's how we get to a view where we want to underweight credit as a whole, but still find attractive switch opportunities out there by taking advantage of the relative performance between sectors in 2022.

Dan Krieter:

And then Dan, before we wrap up today's episode, I did want to spend at least a little time talking about SOFR because SOFR is still printing about 10 basis points through the Feds RP program. Now a full week since the Feds June meeting, and we're still 10 basis points below, been a lot of market chatter about this in the past couple days. And I think it's a topic that's worth talking about on the podcast to try and get our arms around what's going on and what to expect with SOFR in the weeks ahead. So, I guess I'll give you a pretty open ended question to begin here. What's driving SOFR printing solo.

Dan Belton:

So, I would point to any of three or four factors, but primarily the predominant theme in money markets over the past year and change is that there's just a glut of cash in the front end of the system without many great investment opportunities for that cash to go to.

Dan Belton:

SO right now, we have bills trading well through their match maturity OIS, and that exceptional richness and bills has left a lot of the participants in the front end looking to put their money in the reverse repo facility, which yields 155 basis points right now. And even that facility and it's 160 billion counterparty limit has become overwhelmed in recent weeks. And so money has spilled over from that into the repo market. And as that glut of cash goes to the repo market, it bids down rates. And that's why we have SOFR, which is of course a median weighted repo rate trading, 10 basis points below the RRP rate.

Dan Krieter:

So Dan, you mentioned something there that I want to spend a little bit more time talking about. You talked about some potential frictions regarding access to the Feds RRP facility resulting in the capacity being, I think the word use was overwhelmed. That's a bit difficult to square with the fact that now there's 160 billion dollar counterparty limit per counterparty to access the Fed's RRP program. Difficult to think many, if any, counterparties are at 160 billion. So, how is the facility being overwhelmed despite such an astronomical counterparty limit?

Dan Belton:

Yeah, so there are internal limits within money market funds who access the facility and without making sweeping generalizations, there's a couple from a regulatory rating standpoint, for instance Fitch for triple A money market funds limits exposure to a single counterparty to be 25% of NAV.

Dan Belton:

And so, that's going to be somewhat of a limiting factor for some of these funds, more limiting than the 160 billion counterparty limit. And then there's other internal policies and procedures that these funds need to adhere to, which might prohibit them from putting all of their money or 160 billion worth of their assets at the RRP facility. And again, without making too much of a generalization around it, I think there are just other frictions beyond that counterparty limit that the Fed puts in place.

Dan Krieter:

There also is another potential friction regarding just who can access the facility. Now we know that state and locals are huge users of RRP and they are not able to access Fed liquidity directly. Certainly, they can do so via money market fund holdings, but state and local funds remain flush with stimulus money that until very recently was still flowing into the states with no obvious home that ends up invested sort of under the curve.

Dan Krieter:

So, they can't access the RRP directly. And certainly, they have their own individual counterparty limits as well. So, I agree with your point holistically, it's not easy to point to one friction and say, this is the problem. If it were that easy, there's probably a strong argument that friction would've been resolved.

Dan Belton:

And all that said, just to point out, the RRP volumes right now are over 2 trillion. That's over double the size of daily SOFR volumes of around 900 billion to one trillion. So it's not like these frictions are outright prohibiting access to the RRP facility. It's just that not all of the money is leaving the repo market to go sit at the Fed's RRP.

Dan Krieter:

Yeah, there's just still way, way too much cash. And QT has only just begun in the past what? Couple days. So, we haven't really seen any real reduction in money supply yet. So there's still just too much cash. And there are some frictions at the RRP that are likely being exacerbated by some of the factors you discussed before, the uncertainty around the Fed with lack of short term collateral options and how rich bills are trading. And another factor probably that's worth consideration in terms of where SOFRs printing is just the volume of specials we had recently.

Dan Belton:

Yeah. Specials peaked on Friday by our measure, which looks at the average repo rate of on the run Treasuries relative to the GC rate weighted by volumes. And so, that was on Friday. One of the most extreme levels that we have on record going back about five years, and that's moderated somewhat and should continue to moderate with this rally and Treasury yields that we're seeing today.

Dan Belton:

But as we saw yields continue to March higher and higher, that really put pressure on some of the specials, which we've talked about in the past that put pressure on some of these on the run Treasuries in the repo market. And as we've talked about in the past, that can just mechanically bias the SOFR rate lower just as some of these special volumes feed into the rate. Even if the bottom 25% are omitted, they can still bias the rate lower.

Dan Belton:

And I just want to circle back on the point on front end volatility front end rates have gotten absolutely crushed during different parts of this year. If you look at the two weeks leading up to last Wednesday's FOMC meeting, they marked two of the worst weeks on record from a total return standpoint in the ice, zero to one year treasury index. So, investors in the front end as this policy rate uncertainty heightened leading up to that Fed meeting, had some real losses in the front end and the only real way to hedge that uncertainty and the volatility that we're seeing with respect to the Fed's reaction function is to hide out in overnights. And I think that's what we're seeing a lot of.

Dan Krieter:

Yeah. I mean, that all makes sense. So, I think we've talked about some of the reasons why SOFRs printing so low, I guess the trillion, multitrillion dollar question now is what does this mean looking ahead? And will SOFR continue to print here for an extended period of time? We know that this week is the GSE float period where GSE cash is in the market.

Dan Krieter:

Looking at the daily RRP counterparty volumes that the Fed releases up through the end of April. We really only see about a 50 billion bump give or take 10 billion from the GSC cash. I mean, that's certainly not nothing, but in the context of the amount of SOFR volume being done below the RRP, 50 billion doesn't seem to be the determining factor here that is in the market this week, though. That's going to come out next week. I don't think that alone is going to drive SOFR back in line with the RRPs, so what's the view in the weeks ahead?

Dan Belton:

Yeah, I think SOFR is going to continue to print below the RRP rate for the foreseeable future. Maybe not 10 basis points below where we are today. Starting next week, I expect to see it move higher slightly. Just given that specials are likely to normalize. We should see some of this policy rate uncertainty dissipate a little bit. And then, like you said, the GSE float period, but this mismatch of supply and demand in the front end and that the richness of all investment opportunities is likely to persist at least until the Fed's QT starts to really progress here. And then, we're a couple months away from that at least.

Dan Krieter:

Yeah, and that does bring one more issue to mind that we haven't talked about recently, which is heading into QT. And while the Fed was announcing it, it was all a big issue of how QT was going to actually hit the Fed's balance sheet. Would it be the RP volumes going down or reserve balances going down? And I think, we in most of the street, the consensus became that RPP volumes would be sticky, at least in the early phases of QT in the early going.

Dan Krieter:

Most reductions and reserves would come out of IOER and from bank balance sheets. Given a sufficient magnitude of reserves coming off of banks, and we don't know what this number is obviously, but there is some number where banks will potentially begin to become over collateralized and will want to attract deposits out of the entities accessing the RRP including money funds, which is by far the biggest. So at some point, we'll see banks begin to compete for those deposits. And it's at that point that RRP volumes should begin to fall rather quickly. But I don't think that point in time is generally very soon, maybe by the end of 2022, but I don't see it in the months ahead.

Dan Belton:

Yeah. I mean, we have just such a massive cushion right now that it's going to take time.

Dan Krieter:

Yeah. And so I guess, what does this mean for our markets? Looking at SOFR floaters is one of the fewer areas that are directly tied to SOFR. We've seen some cheapening up in SOFR FRNs obviously in the past couple days and weeks, and I don't necessarily think that's going to change in time. And I do think, at some point in 2022, there will be an opportunity to buy SOFR FRNs. And you'll see some performance there as the index recovers or maybe more accurately RRP volume start to decline rapidly, but we're not there yet. I think we are at the end of this podcast though, Dan, unless you have anything else to add?

Dan Belton:

I think that covers it. Thanks for listening.

Dan Krieter:

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, B-E-L-T-O-N@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 and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:

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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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