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Into the Frying Pan… - High Quality Credit Spreads

FICC Podcasts Podcasts September 28, 2022
FICC Podcasts Podcasts September 28, 2022

 

Dan Krieter and Dan Belton discuss the recent volatility in credit and swap spreads including their year-end targets for credit spreads. Other topics include whether swap spreads can continue to narrow from here, why credit had been so resilient until this week, and the impact of central bank intervention on credit and swap spreads.


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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 September 28th out of the frying pan. I'm your host Dan Krieter here with Dan Belton as we discuss extreme market volatility in the past week and what it means for credit and swap spreads going forward. 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 email directly at Dan.Krieter, K-R-I-E-T-E-R@bmo.com. We value and greatly appreciate your input.

Dan Krieter:
Well Dan, after elevated volatility for the majority of 2022, I think most of us would've agreed heading into September that things really probably couldn't get much worse. And now we have the events of the past week where volatility is just spiked again with historic moves in many asset classes, including one of the largest increases in real yields since the financial crisis. A historic move in swap spreads, just volatility everywhere. But beginning with the focus of this podcast, which is credit, the volatility has not been historic. In fact, credit has been, while we are starting to see some movement now, has been relatively well anchored. And I think the overriding high level theme that we would use to describe credit in the past couple weeks has been resilience.

Dan Belton:
Yeah, resilient or complacent. I would probably go with complacent at least until the past few sessions. Credit spreads hung in very well. We opened this week about 15 or 16 basis points inside of year to date wides, and that's in contrast to equities which were at year to date lows, mortgage spreads at year to date highs and even CDX depending on how you adjusted for the role, that was also at highs. And so, we and a lot of clients that we've been talking to and other market participants have been scratching our heads wondering why credit has been so complacent or resilient over the past month. And I think one reason that I'm sure we'll talk about later on in this podcast has been support of technicals, but then we've started to see spreads move wider this week. We're about 10 base points wider over the past three sessions, and I think that's just the beginning of what's going to prove a very durable move wider in credit.

Dan Krieter:
Let's start with some of the explanations that have been thrown about because obviously this resilience in credit or complacency as you put it, has garnered some increasing attention, some increasing headlines from the media and there have been some explanations put out there. They include crossover buyers from the high yield market enticed by all in yields that we haven't seen in a decade in IG. And high yield buyers tend to be more all in yield focus. And given the risk out there that there's some thought that high yield buyers are coming into IG given elevated yields, we've seen some explanation coming from crossover buying from equities. Given potential for slowing economy here, some equity buyers are finding the higher placement in the capital structure for IG debt as more attractive. The thought being that they would potentially be more insulated from a slowdown in growth. And then there's also been a focus recently on the stronger fundamentals in the credit market that corporations in aggregate are better positioned from a balance sheet perspective heading into this economic downturn than they have been in the previous two economic slowdowns.

Dan Krieter:
And that is undoubtedly true. Still, I don't find any of the three explanations overly compelling. We'll start with the high yield one. I mean the investment grade market is multiples the size of the high yield market. And so if we were seeing flows out of high yield and into IG substantial enough to meaningfully support IG spreads, I would personally expect high yield investment grade spreads to be near the wide end of the historical range, at least excluding periods of crisis. And that's not the case. In fact, high yield spreads are just inside of their long-term average compared to investment grade. And that doesn't jive with this idea that we're seeing massive crossover buying supporting spreads. So I don't buy that one so much.

Dan Belton:
Yeah, the resilience we've been talking about in IG, that really applies to high yield too. High yield spreads are not at year to date wides like we would expect given where most other asset classes are trading. So while it might be true on the margin, sure some high yield buyers are moving into IG just as a way of de-risking, but that's probably not the primary driver of this resilience in credit.

Dan Krieter:
Yeah, I mean to some extent, I'm sure these drivers are all somewhat true at the margin, but not even looking at the equity one, it makes sense on its face that you want to be higher in the capital structure heading into a recession or severe economic slowdown. But there's been a lot of headlines recently looking at the difference between corporate bond yields and equity earnings yields. And for the first time in 12 years, bond yields now above earnings yields. I have a hard time squaring that with this idea that there's a lot of crossover buying from equities into IG. If that were the case, we'd expect downward pressure on bond yields as corporate debt is bought and upward pressure on earnings yield as equities are sold. We've seen the opposite.

Dan Krieter:
So I don't see how we can make the argument that there's a lot of equity crossover when those yield dynamics are at play. And then finally, the stronger fundamentals argument. I'm not saying that's not true, but most certainly is true, we have seen a lot of balance sheet prudence this year for the corporate power in aggregate. And leverage ratios have fallen and balance sheets are in a generally healthier place.

Dan Krieter:
But there's this logic that well balance sheets are healthier now than they were back then and we made it through back then, so we should be fine now. Well, but those last two economic downturn required massive intervention from the central bank that we can't at this point be expecting given the Fed's fight against inflation. Sure, in a severe enough crisis we might see the central bank coming in providing liquidity to the market if it needs it. But certainly in that instance we're going to get a severe spike in credit spreads before that happens. And if we don't see that liquidity need, the Fed is not going to be coming in with accommodative monetary policy, it's going to short circuit a default downgrade cycle, which we've been talking about. We could see a more sustained default downgrade cycle in the current environment than we've seen in the previous two economic slowdowns.

Dan Belton:
Yeah, you'll remember back in 2019, corporate fundamentals were pretty weak heading into the pandemic. We had cash ratios very low, leverage pretty high, and we thought that was a sign of some pretty fundamental weakness that was going to bleed into credit spreads in a durable manner and it ultimately didn't. But that's because the Fed came in and the fiscal authorities as well, came in with unprecedented policy support, which brought interest rates down to zero and the government spending kept the economy going at a reasonable pace to allow revenue streams or at least cash flows to continue to come in and support corporate balance sheets. That's not going to be the case this time. We saw how the market reacted to England's fiscal stimulus and I don't think that we're going to see either fiscal or monetary authorities come in and really provide the support to the private sector that we saw two years ago.

Dan Krieter:
Well said Dan. And that just is why I don't find this argument that stronger fundamentals should mean that spreads are resilient here, very compelling, any of the three, to be honest with you. So why have spreads been more resilient? And I guess we can talk about that very quickly now. To me it's the outcomes raiser. The most likely explanation, you alluded to it earlier is technical tailwinds. I mean September supply as we sit here today is 79 billion versus expectations in the 140 to $145 billion range. And really that's been the trend since May. Outside of a small window in August where we saw issuance pick back up again, technicals have been extremely, extremely supportive and that's likely been a significant tailwind for credit, particularly at this point in the year when investors are expecting heavy supply and have set aside cash to put to work in that market.

Dan Belton:
Yeah. And that's why September, even during years of heavy supply tends to be a seasonally supportive time for credit spreads. There's no doubt that we're seeing that right now with issuance falling almost half as much as expected. We have no issuers in the market today. We might have some supply tomorrow, but we're likely to finish the month in the $80 billion range or so, maybe a little bit higher. And so as investors have this money that they've earmarked to put to work this month during the last seasonally heavy issuance time of the year, there is some bidding for credit spreads even while anecdotally, there's a lot of investors who are very wary of credit spreads at the current point in the cycle. So it makes a lot of sense to me that credit has been well bid here, but it's likely that that support's going to run out.

Dan Krieter:
At least well bid compared to other risk assets because we are seeing widening like you said, and just to put it in numbers very quickly, this will be the lightest September supply since 2011 and the lightest by a wide margin. So supply side technicals have been extremely, extremely supportive. But it's not just technicals either. I mean you look at the July, August narrowing in credit spreads and there was an undeniable increase in optimism around the economy and the path of earnings with financial stress indices falling, with earnings provisions moving much higher and expectations that the worst case scenario as we talked about in previous podcasts wasn't going to look so bad. I think that's been completely reversed now. And as we walk away from the desk today, I think financial stress is at the 2022 peak as we speak right now, and our expectation this whole time was for financial stress to make a new peak and by a wide margin. So just the fact that we're at the peaks now doesn't tell me that we're nearing an inflection point. I think stress will only continue to worsen in the weeks ahead.

Dan Belton:
Yeah, the Fed is certainly on board with that. We've heard Fed speakers, as stress subsided and the summer months Fed speakers have come out subsequently and talked about how they were disappointed to see that. So the Fed is actively trying to continue to tighten financial conditions and they're likely to succeed in doing that.

Dan Krieter:
And one last support factor that I know we've said in previous podcasts, but at least bear's worth mentioning again, is just the supply of reserves in the system that mechanically pushes investment out the credit spectrum. There is still a ton of reserve supply in the system and we know that will continue to fall in the months ahead alongside quantitative tightening, which it's a slow drag on spreads, but it's an important one that we have to keep bringing up because I do think the supplier reserves in the system is another reason why risk assets broadly have proven more resilient in particularly corporate bonds.

Dan Krieter:
So Dan, if those are the main reasons for why we've seen perhaps more resilience or complacency as you put it in credit spreads in these past few weeks, technical tailwinds, some increase in optimism at least a few weeks ago, and then finally reserve supply. Let's talk about now the outlook for spreads from here. I mean we've long held our target in the 170 to 175 basis point level for the broad IG index, which represents both at this point in the year, a near term view and our year end target. The question for us has to be, has that changed? Not likely are we revising it lower? I think the question now is are we revising that target higher?

Dan Belton:
Yeah, so in the ICE index we're at 158 basis points. I think given the macro events of the past week, the risk is certainly to spreads finishing the year wider than that 175 basis point level. I'd see more likely somewhere in the admittedly wide 175 basis point to 200 basis point range I think is a reasonable expectation for where we could see credit spreads finishing the year. Obviously a lot of uncertainty, a lot of volatility here. So our model for credit spreads has fair value at least as of Friday at 165 basis points. So as of Friday, we were about 10 to 15 basis points wider than actual levels. Credit spreads are starting to converge to that level, but I think the fair value into year end is going to continue to move wider. And there's been three factors that have been driving our model implied valuations wider for credit spreads this year and those are 10 year Treasury yields, a deterioration in corporate rating actions and financial conditions.

Dan Belton:
And in the last two of those, financial conditions and deterioration and corporate rating actions are likely to continue to get worse. So corporate ratings, we've talked about this in many podcasts recently, but those for the first time in August and September turns net negative for the corporate market as a whole. We saw more grading downgrades than upgrades in each of the last two months and that's likely to only continue to worsen as the economic outlook dims. So we've already talked about the likely trajectory of financial conditions continuing to move tighter. So I think somewhere north of 175 basis points at this point is much more likely than anything less than 175.

Dan Krieter:
Yeah, I was going to say, you talk about the impact of higher financial stress and the quantitative model as of Friday, we had a fair value of 165 basis points. Even that target is certain to be higher now given the move in financial stress just on the week. But you talked about the quantitative fair value for spreads. I also want to talk about some of the unquantifiable factors that will likely putting upward pressure on credit spreads in the near term. And that is just the difference in Fed policy between the current environment and previous economic slowdowns that we talked about earlier in the podcast. Real yields, this is a point that needs to be stressed because after the move in real yields last week, we're now at the highest real yield and 10 year Treasury since 2010.

Dan Krieter:
And you can look at any risk asset you want and chart it alongside real yields. And we are looking very overvalued, whether that's IGs credit, whether that's high yield credit, whether that's equities, PE ratios. I mean real yields, that is the definition of tightening financial conditions. And given the move we've seen in real yields, we're still very overvalued from that perspective. And I find it hard to believe that real yields are going to be going down significantly in the weeks ahead.

Dan Krieter:
It's also worth mentioning just everything that's going on in the UK right now. I mean this morning's announcement that really surprised the market that the Bank of England was going to embark on another round of quantitative easing, I'll call it QE, just for ease. I'm sure our listeners know the distinction. That was something that was probably inconceivable a week ago and now here we are. It just highlights the elevated uncertainty, the cracks that can come quickly, and from areas that you likely wouldn't expect and that can easily happen in credit markets going forward. There can be cracks coming to the surface that will quickly reprice spreads. And then lastly, I think we should talk about central bank intervention, which has been another key theme in the past week after the Bank of Japan announced intervention on behalf of the yen last week. We saw headlines that the Bank of Indonesia was doing so this week. There are likely other Asian economies embarking on intervention whether directly or indirectly here going forward. And that also likely represents a headwind for credit spreads.

Dan Belton:
Yeah, when you look at the decline in foreign currencies relative to the US dollar now versus in 2015, it's very similar in magnitude. And so there's reason to expect that like in 2015, there's going to be a lot more central bank intervention selling of US dollar assets. And this isn't likely to be primarily a credit story. Foreign central banks only hold about 5% of all foreign held US dollar corporate bonds. So they're not a very large holder of the US dollar corporate bond market. But it could have a significant impact on liquidity and that would likely cheapen all US dollar fixed income assets. So if there's significant selling of Treasuries by foreign central banks, there could be a crowding out effect that leads to wider credit spreads through the portfolio balance channel much like the reverse of quantitative easing as investors are pushed in the risk spectrum into Treasuries out of corporate bonds, sending credit spreads wider. And I think liquidity, which is already very challenged in the corporate bond market, is likely to worsen if we see more central bank intervention.

Dan Krieter:
That's exactly the dynamic we saw play out in 2015. Like you said, foreign central banks not significant holders of corporate paper and what holdings they did have, did not decline in 2015, 2016 in the last major round of central bank intervention. We still saw spreads increased very meaningfully in 2015. Obviously our listeners will remember that very well, as a result of crowding out of private debt and decreasing liquidity in financial markets. That's certainly going to be the case and likely even more so this time around given how poor liquidity is already for both Treasury and corporate bond markets. So central bank intervention which could last for a while here just adds to the reason to think that we're going to see more upward pressure on credit that even the models don't necessarily capture.

Dan Krieter:
So obviously very bearish here. We agree on that Dan. You put a 175 to 200 basis point target on credit spreads by the end of the year. I think I'll take the upper end of that range more in the 185 to 195 basis point level. And before we wrap up, Dan, obviously given the discussion we just had on central bank intervention, I do think we have to touch on swap spreads here as well after a historic narrowing in swap spreads in the past couple sessions. Monday alone we saw two year and three year swap spreads narrow seven to eight basis points, easily the largest single day move for SOFR swap spreads in the history of the market. Granted we don't have a lot of history there, but even looking at like Treasury OAS spreads, which are basically the inverse of SOFR swap spreads, we can see the move in two year Treasury OAS being the largest sense of financial crisis except for a few days in March of 2020.

Dan Krieter:
So a really historic move in swap spreads early in the week. Of course that's due to central bank intervention, which we know has a massive impact on swap spreads. Now I think given the highly technical nature of the move in swap spreads, we have to ask ourselves here, is this a buying opportunity now?

Dan Belton:
Yeah, I don't think so just yet. I think there's certainly more potential for continued selling by foreign central banks and I think only once that selling has likely been done or at least priced into the market fully, can this represent a selling point. There's not really an obvious technical threshold for SOFR swap spreads where we're going to see a floor in how tight they can trade. I think it's just going to be one of those things where there's going to be volatility in the asset class for a very long period of time and we're going to have to watch headlines and see how foreign currencies are holding up against the dollar and whether there's continued selling pressure. But I wouldn't stand in the way of this momentum at this point.

Dan Krieter:
Yeah, because even if you look at the long term chart, we're still not at extreme levels in terms of two year Treasury OAS or even two year swap spreads. There's plenty of room to go. I mean we were at extreme levels heading into this central bank intervention as a result of the overwhelming demand for RRP. So this unwind of that amid central bank intervention is just moving us more toward the middle of the range. There's plenty of room to go here. And if you look at the pattern of central bank intervention in 2015, it was highly concentrated at the front end in the early stages. In fact, looking at 2015 to early 2016, foreign central banks sold short-term Treasury securities to the tune of about 100 billion where long-term Treasury holdings only declined about 20 billion. Moving into 2016, we started seeing more asset sales of long-term Treasuries and short end stabilized.

Dan Krieter:
But in the initial stages when we saw the initial shock to the financial system, naturally central banks went to the more liquid part of the curve at the short end. That same logic holds here, particularly with liquidity so poor further out the Treasury curve, it makes sense that if you're intervening, you're going to go to the most liquid part of the curve, which is the front end. So I think we could continue to see pressure on the front end. So while we like swaps or narrows across the curve, that's particularly true for the front end and I think we could see front end belly spread steepen here. That has happened in the past few sessions. I think it could continue not just because of downward pressure on the outsized impact that central bank intervention has on the front end, but also I do find some reasons to believe that the belly could be somewhat supported or at least supported to a higher degree than the front end going forward.

Dan Krieter:
And a couple reasons for that. First, last week's FOMC, we saw the Fed strongly rule out any changes to QT. It's going to remain on autopilot. Now there had been some concerns, at least from my point of view, that the Fed could look at alternative ways of tightening financial conditions given inflation still elevated despite the increase in rates. And that could mean asset sales from MBS, it could mean potentially higher caps in QT. Admitted the bar to that would be high, but I thought the Fed could just talk about that and tighten financial conditions, which would put pressure on belly spreads. Powell ruled that out. I also want to make note of an interesting trend we've seen from home loan banks recently, which has been a sizeable increase in the rates offered for discount notes. Clearly the home loan banks are looking to issue discount notes here, which is a bit of a surprise because it would imply increased advanced demand on the other side and that seems hard to square with higher rates.

Dan Krieter:
Why would banks be looking for more funding from FHLB? Well, if you look at that through the context of the investment grade market where the prime market is pretty much right now, we haven't seen a ton of supply, but who knows how executions would look if there was big supply coming to the market. It could be that some of these financial issuers instead of looking at issuing a lot in the investment grade market are instead turning to more reliance on FHLB funding. And that would explain an increase in advancement and would explain why the FHLBs are looking to raise discount notes.

Dan Krieter:
So if this dynamic is true, we don't have data on it yet, it'll be weeks before we do, but if this dynamic is true, then we could expect financial supply on the belly of the curve to be relatively lower going forward, which would be supportive of belly spread. So narrower for swap spreads as well as steepeners between the front end and the belly. I think we like in the near term. And to your point Dan, I don't know that there's a level that we could put forth as a target here, particularly given the strength of the technical. It's just going to rely on the path of inflation or the path of the Fed. I don't think we can really see front end swap spreads begin to perform again until we see convincing evidence that the Fed is nearing the end of its hiking campaign and we're just not there yet.

Dan Belton:
Yeah, I mean I think by the end of last week, front end and two, three, five year swap spreads were probably about five to six basis points too wide on the curve. Obviously we've blown right past those levels given the volatility we've seen this week. It's just at this point it's too hard to put a target on front end swap spreads. But I do think, like you said, if you believe that the Fed is not going to blink anytime soon, the impact of quantitative tightening is just going to continue to present narrowing pressure on swap spreads across the curve. So I agree with your conviction on the steepener, but I think narrower swap spreads across the curve is probably a good medium term bet.

Dan Krieter:
So looking at today's pop and spreads on the back of the Bank of England is an opportunity to sell. Makes some sense to us here. Well, we covered a lot, Dan. A lot going on nowadays. Good luck, everybody out there. Getting pretty scary. We'll be back again in a couple weeks. We have a round table with the whole team next week that puts us off our schedule, so we'll be back in a couple weeks.

Dan Belton:
Thanks for listening. 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 the FICC Macro Strategy Group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:
The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

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

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