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Happy Holidays Ahead? - High Quality Credit Spreads

FICC Podcasts Podcasts October 26, 2022
FICC Podcasts Podcasts October 26, 2022

 

Dan Krieter and Dan Belton discuss how the events of the past week alter their views on credit into year-end and early next year. Topics include whether the Fed’s messaging last week constitutes a pivot, improving primary markets, and the likely path of market technicals into the end of the year.


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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 October 26th. Happy holidays ahead. I'm your host, Dan Krieter, here with Dan Belton as we discussed why the Fed's mini pivot last week and support of technicals going forward could result in narrower spreads between now and the end of the year.

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.

Well then, credit spreads are roughly five basis points narrower in the week since our last recording, continuing to underperform other risk assets for sure, but it definitely feels like tone has improved more than a five-basis point rally here. Obviously, a lot has happened in the past seven days, most notably the Fed's potential pivot last Friday with the Wall Street Journal that was then followed up by Fed President Daley's comments. So let's start there. The question everyone is wondering, did the Fed pivot last week?

Dan Belton:

 

No, I don't think they did. The Fed clearly messaged at the bar to go 75 basis points in December is much higher than the market might have thought before the Wall Street Journal article on Friday, but I think that's more a function of where the Fed funds rate currently is and how far the Fed thinks they still need to go. By going only 50 basis points in December, the Fed affords itself a lot more flexibility with respect to slowing the increases in the policy rate, but it doesn't necessarily, at least to me, signal that the Fed is going to favor a lower terminal Fed funds rate.

So if the Fed were to go 75 basis points in both November and December, the year-end policy rate would be 4.50 to 4.75, which is exactly where the Fed signaled terminal would be at the end of 2023 as recently as the September FOMC. So if the SEPs from September are still more or less valid, that would result in a much more significant turn in terms of Fed policy stance, going from 75 basis point hikes to pretty quickly pausing early on in 2023. And I don't think the Fed wants to do that because that could result in a pretty significant rally and risk assets, which the Fed has been trying to avoid.

Dan Krieter:

 

Yeah, it's a good point. I mean, I think whether or not the Fed pivoted comes down to do they want to see financial conditions continuing to tighten or not, and the Wall Street Journal article was very clear with the fact that they do want to see financial conditions continuing to tighten. Tim Rose talked about the response to the July FOMC that then Powell had to push back against in Jackson Hole because they didn't like to see the big sustained rally in equities following July FOMC. He talked about potentially using the SEP that we'll get in December to message more smaller rate hikes in 2023 to try and ensure that the market wouldn't take a step down from 75 to 50 as dovish and we wouldn't see financial conditions continue to ease.

So yes, I don't think it was a pivot. I think that you are right, though. It's time to downshift to smaller hikes and the question will be now when those smaller hikes end. And, of course, we shouldn't rule out the possibility for 75 in December. I mean, it's going to be, of course, very data dependent between now and then. We get two more inflation prints, two more jobs reports before the December FOMC that are going to be what determines how big not only that rate hike is, but also, what they message in terms of terminal in the SEP.

We should note here that the Fed has sort of done this now since the May meeting where they've continually tried to message hawkishness at the next or current FOMC meeting if it's on an FOMC date. But then, some degree of dovish for or guidance for future meetings. All the way back in May, we were not actively considering 75 basis points to then raise 75 in June. At June, we don't expect this to be very common. We've had at least 4.75 [inaudible 00:04:06] now and then, you get into July and September and we're talking about at some points, it'll be appropriate to pause.

So they've demonstrated this desire to be dovish with or for guidance, yet hawkish in the moment. And so the journal article on Daily coming out one day before Fed blackout, it makes sense through that lens. Now, I agree with you that the bar to 75 is now higher, but it could very easily prove to be 75. It will all be data dependent. But on that front, the past seven days has also brought some increasing evidence that things maybe are starting to slow, and I think that's potentially most visible in the earnings reports we've gotten so far for Q3.

Dan Belton:

 

So as we've talked about here, one caveat with respect to earnings reports this quarter is the downward revisions that we've seen out of analysts in the lead up to the earnings releases this quarter. But that said, earnings have come in so far. We've got about 1/5th or 1/6th of earnings releases underway for the high grade borrowers we track, and they've come in pretty strong relative to those expectations, both in terms of revenues and net income.

A couple credit specific things that we're tracking. On the positive side, we've seen leverage continue to come down. Total debt to EBITDA has declined for nine straight quarters for the median IG borrower we track, so a pretty significant continued de-leveraging trend going on. But a couple more concerning trends in the high grade universe, at least that credit investors will want to remain cognizant of. First, we've seen a continued decline in profit margins for the median borrower in the high grade universe have fallen below any post-pandemic observation and now reside below 2019 levels. Cash holdings continue to fall after declining by 7% from the previous year. In the second quarter, we're seeing similar declines in Q3 from last year's third quarter in cash holdings. And then, interest coverage, which last quarter were at all time highs for the high grade universe, those have fallen as well just through the early reports that we've seen this quarter.

So the really extremely healthy balance sheets that we've seen in the wake of the pandemic starting to come off a little bit, not really acute reasons for concern in the near term here, but starting to see a moderation in balance sheet health. And I think in the near term what I'm watching for is cash ratios, particularly among the triple B borrowers that have been more or less locked out of the primary markets this year, wanting to see how those evolve as more earnings reports come in and seeing if there's going to become a more near term need for issuance out of those borrowers.

Dan Krieter:

 

Yeah, for me, earnings have sent quite the mixed signal because it started off with the banks painting a pretty strong picture, particularly for the consumer, talking about the consumer still extremely strong and demand remained very healthy, credit card [inaudible 00:06:42] is very, very low. And then we get the tech earnings coming this week, which obviously disappointed. We still have more tech earnings to come, but Microsoft and Google disappointing, which some are viewing as a canary in the coal mine with weaker consumer strength, weaker demand for ad sales. And it hasn't just been in earnings reports either. We have seen rent starting to slow. We've seen some metrics of the employment market starting to soften a bit, not some of the more bellweather gauges that we're waiting for those next week, but some of the more secondary economic data perhaps starting to indicate that some of the Fed's restriction is starting to be felt to the broader economy.

So I think if you're the Fed and you're looking at this and you're seeing, I don't want to say disappointing earnings because like you said, they're coming above the bar, but certainly not impressive corporate earnings. We're starting to see some of the economic data slow down. That's going to give you more confidence that 50 basis points is going to be the rate rise in December. We just need to see confirmation of that in the two employment points and the two inflation reports we're going to get before the [inaudible 00:07:34] FOMC.

So now let's look at things from a credit spread standpoint. Because in our episode last, we talked about where we expected the cycle peak in IG credit to be, and we thought it'd be in the 220 to 225 basis point range. And certainly, in the week since then, things have started to look much more constructive, and I want to check in with you and see if your view has changed at all in light of the events of the past week.

Dan Belton:

 

So broadly, they haven't. I still expect the cycle peaks to be about 225 basis points. I think the timing might be a little bit different now, just in light of the fact that the Fed seems likely to be slowing the pace of rate hikes in December, which wasn't really what I expected. I had expected more likely, it would be 75, 75 followed by a down shift to 50, then 25. I still think there's an upside risk to where the terminal Fed funds rate goes relative to where the market is pricing it. I wouldn't be surprised to see a five handle on the terminal Fed funds rate. I just think we're going to get there maybe a meeting or two later than I would've thought a week ago.

In terms of our year end target, I'm losing conviction that we're going to see 190 at least in December of this year. I think more likely now, the path of credit spreads is going to be somewhat stable into year end. Obviously, volatility is likely to remain in the near term alongside economic uncertainty, but I'm roughly neutral in terms of credit spreads into year end. I think once we start to see economic weakness unfold, call it in late Q1, early Q2 of next year, that's when I'm expecting credit spreads to start to move considerably wider. I'm looking for credit spreads to make their peak in Q2 of 2023.

Dan Krieter:

 

Yeah, I agree with you that the big change in my view over the past week has been timing as well. I certainly still believe in those targets as long term targets are the cyclical peak. But regarding the near term view, I think definitely, the target we had of 190 is going to prove too high and we're going to have to move that lower. The question for me now is do we think credit spreads are going to finish wider or narrower than current levels? And I'm really starting to think that there's a pretty strong chance spreads will end this year narrower than where they are currently.

And the reason is primarily because if we start to see slowing in inflation, maybe some weaker jobs reports, the first impulse for investors will be to trade a more dovish Fed, and that's obviously going to be supportive for credit spreads. So I think heading into next week's FOMC, particularly in light of what Bank of Canada did today, raising rates only 50 basis points and next week's employment report, I think you want to be long heading into those events because I think that's going to start setting the table for, of course, a 50-basis point hike in December, but a broader perception that the Fed is pivoting here.

Now, I still don't think we're going to get a soft landing. I think that's going to prove extremely challenging. So when credit spreads hit their cyclical peak, that's going to coincide with fears of recession, a relatively lighter response from the Fed coinciding with the recession than what we've had in these past few cycles and credit fears driving that next leg wider in credit spreads. But in the very near term, I think the first trade will be pricing in a more dovish Fed and that's going to be supportive for credit spreads.

Dan Belton:

 

I think another factor that increases the near term attractiveness in credit is what's happened over the past few weeks as the backdrop has improved. So if you look at CDX over the month of October, CDX spreads are about 15 basis points narrow around the month. Cash credit has not participated at all in that rally. Index spreads are about one to two basis points wider over the month. And to me, this is partially over due in just a move of credit spreads moving in line with really where they should've been trading for much of the last few months.

I mean, if you look at the vast majority of our client conversations, our conversations with the trading desk and sales people, there's an overwhelming sentiment that credit is really unattractive here. That's apparent through any list of market metrics. If you look at net selling interests from clients, if you look at liquidity, credit's been a very unattractive asset class for the last few months and credit hasn't performed very well this month as the backdrop has improved and we've seen primary markets improved this week as well. This, to me, is just a resetting of index spreads to more in line with fundamentals and it makes it more attractive for me right now.

Dan Krieter:

 

Yeah, I like the way you put that maybe spreads are getting to where they should have been because I mean, our original target for spreads was 178, 175 basis points, which is where the index has traded these past couple weeks or very near there. And maybe the move to 190 year end proved misguided on our part. But to your point, sentiment has been very bad and spreads have now underperformed risk assets for the past couple weeks.

But another thing has been very apparent throughout the course of the year and that is the sort of fear of missing out on the peaking credit spreads. We've seen four independent peaks and credit spreads this year, and each one has been followed by a pretty sharp rallying credit as investors were afraid that they were missing the peak. And I think heading into next week in some big macroeconomic data that's going to be released in the next couple weeks, obviously the FOMC for November next week as well. If that comes in as dovish and if the unemployment report isn't super strong again, you're going to see risk sentiment improve.

And I think that's going to build upon itself from momentum perspective with investors potentially thinking this is the Fed's big pivot. This is the peak in credit spreads. I can't miss this peak. And you'll see some near term outperformance there that will likely reverse in the first half of 2023 as now, we start to focus more on growth concerns than inflation. So I am turning much more bullish in the near term here, and I think technicals are another big reason for that. You alluded to it, but supply side technicals have been very supportive and in this week, we've seen very encouraging executions from the primary side.

Dan Belton:

 

Yeah, I'm thinking of this week as maybe the most constructive primary markets we've seen all year or maybe since the first week of the year. So on Monday, we saw heavy triple B supply, which we haven't really seen much of in the past few quarters and that was pretty well received. We saw new issue concessions averaging about seven basis points. And then yesterday, we saw, of course, the UnitedHealth jumbo, which was part of $12 billion in supply. And that supply averaged just two basis points of concession with order books this week coming about three times covered.

And so this week's about four basis points in new issue concessions is actually the lowest since the first week of the year, excluding weeks with very light issuance. And so I'm seeing a lot more reason for optimism, given this week's supply so far. Obviously, there's a lot more ways to go. It'd be nice to see primary markets continue to perform this well, but after months and months of double-digit, new issue concessions on average, I think it's a welcome change for all market participants to see primary markets start to really function again and especially after we had such lack of supply over the past couple of months.

Dan Krieter:

 

Yeah, today's going to be another important day. We have three financials in the market today. We know financial spreads, given the amount of supply there's been, have sort of struggled here in the past few months. So if we see another day of strong executions today with the financial heavy slate, I think that'll be a very important indicator that the near term metrics are pointing bull.

[inaudible 00:14:19] looking out for the remainder of the year, I mean, I think that technical should remain pretty supportive. We talked a bit about demand earlier, but I think supply is going to remain relatively light and I think it's worth talking about the issuance, or lack thereof, from the big American banks after Q3 earnings releases. We've seen, really for the past couple years, like clockwork, earnings reports come out and then we see massive issuance from all the American banks. That didn't really happen this year. We only got Morgan Stanley's $6.5 billion deal. That was the only [inaudible 00:14:46] that was borrowing.

And I think that speaks to some of the balance sheet constraints at banks we've been hearing a lot about, capital buffer concerns, some leverage concerns there as well. So banks' supply probably going to remain very, very light heading into the rest of the year, at least until January. And so I think supply, as a whole, should remain pretty supportive, particularly given how high rates are now.

And before we go here, I want to spend a little bit time talking about SSAs here because given the more near term bullish view we have on spreads now, I still think spread decompression is going to remain a pretty key theme. So as we talk about overweighting spreads into the end of the year, I think you want to do that with very high credit quality names. And if you look at for an IG bar or looking at some of the higher beta SSA names, tier three SSA names could make a lot of sense here with some tier three names trading its spreads roughly comparable to where the highest rated corporations are trading.

And I think regardless of where you are on the credit spectrum, building overweights in the next couple months here should be focused on the highest quality slice that you look at. And in SSAs, I think technical is going to be extremely supportive between now and the end of the year. Heading into Q4, we had a supply projection of just $25 billion to the entirety of Q4 and the risk to that might even be to the downside. And we've seen roughly 10 billion so far, maybe a little more than that in October. That means that for the rest of the year, we're expecting a maximum of $15 billion in SSA supplies. So you've got pretty considerably attractive spreads here and a very supportive calendar going forward that make SSAs an attractive option for people looking to build overweights and credit here between now and the end of the year.

On a quick programming note, we will be back next week with two podcasts. On Monday, the broader Fixed Strategy team is going to release our Macro Monthly podcast that looks at a broader view of fixed income and currency markets ahead of the Wednesday FOMC meeting. And then on Wednesday, Dan and I will be back here in High Quality Spreads immediately following the FOMC to give our reactions to what's shaping up to be a pretty pivotal Fed meeting.

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@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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