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Looking West - High Quality Credit Spreads

FICC Podcasts August 24, 2022
FICC Podcasts August 24, 2022

 

Dan Krieter and Dan Belton discuss the recent performance in credit spreads and what the impending Jackson Hole Symposium is likely to bring for the asset class. Other topics include recent trends in fundamentals and supply, swap spreads, and a possible exemption to the supplementary leverage ratio.


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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 August 24th. Looking West. I'm your host, Dan Krieter here with Dan Belton, as we discuss recent moves and credit and swap spreads ahead of the Fed's annual meetings at Jackson Hole.

Dan Krieter:
Each week, we offer a 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 live board to [inaudible 00:00:33]. 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 then, after an impressive 20 to 25 basis point rally in spreads in July and early August, we've gotten a bit of a backup in credit here more recently. To begin, why don't you just set the table with what we've seen in credit over the past two weeks since our last episode?

Dan Belton:
Yeah. Spreads are out about six or seven basis points since the beginning of last week. Like you mentioned, we are coming off about a 20 basis point rally in credit spread indices. I think the narrative in credit markets is now shifting to whether the lows in credit or the wides in credit spreads for the year are in, or if we just saw a month and a half long bear market rally. We've been of the mind that credit spreads over the past month and a half or so were really just in the process of defining the narrow part of the trading range, that's likely to hold, and that we haven't necessarily seen the wides and credit spreads just yet.

Dan Krieter:
Yeah, maybe pushed a bit tighter than we thought they would in the last month and a half. But I agree through that we're at a point of uncertainty here from credit. You can make a pretty compelling argument either way that spreads will continue widening now after a bear market rally, or that we could see just this being a little blip on the radar with heavy supply in August, and that spreads will soon turn narrower again. So I think that's where we start the conversation for today. I think to look at what happened more recently, we have to go back to what drove the big rally in the six weeks ahead of last week. I think that's where we're going to focus the conversation here today. Where do we think spreads are going to go from here? I think to start, we have to look at what actually drove the narrowing and credit spreads in July and early August, because as you said, it was a stronger rally than we were anticipating.

Dan Krieter:
I think there are two main factors we can point to. The first one was just a significant improvement in corporate market liquidity in July. We can look at this through the Fed's newly released corporate market distress index. I think we talked about this in a previous episode, but it's worth repeating. If you look at that index in June into early July, we saw stress in corporate markets in particular at some of their worst levels on record, going back to 2005 when the data began. In fact, only 2008 and the pandemic in 2020 saw more stress in the corporate market in particular. And that measure looks at both primary and secondary market metrics to come up with the "corporate market distress". The way I view that index is I view it as a measure of liquidity. You look at what goes into that calculation, it's things like concessions, dealer inventories, looking at the price impact of secondary market bonds, when they trade, when index bonds trade. How much does the price change from where the models are marketing them in the index to where actual trade levels are as a measure of market impact, which is clearly a very important indicator of liquidity.

Dan Krieter:
If we view the corporate market distress index, as a measure of liquidity in corporate markets, liquidity just basically fell off the table in June and early July. We've seen some improvement there, which naturally would lead to a narrowing in credit spreads, which also whether, this is causal or just indicative of it, we've also seen demand side technicals improving here in the past couple weeks.

Dan Belton:
It's not hard to remember back in June, the narrative around credit spreads. Nobody really wanted to touch credit. The Fed was at peak hawkishness, going 75 basis points a meeting, and primary markets were really struggling. We saw an average of 16, 18 basis points of new issue concessions, deal after deal. There was just really no demand for new issues, and primary dealer statistics showed low in declining inventories. Anecdotally, just the evidence really indicated that there's just no liquidity. To that point, market sentiment was really at its worst in June. It started to come back since then. We had 18 consecutive weeks of bond fund outflows, which was the longest stretch on record. And I think we saw about $74 billion leave high grade bond funds during that period, and that's snapped three weeks ago. Now, we've actually seen three consecutive weeks of inflows. We haven't seen nearly a commensurate magnitude of inflows, but the three consecutive weeks with the last one totalling about $3.5 billion, I think is evidence of demand starting to return, or at least stabilizing the market where the proposition of taking on new positions and credit given the higher yields and the stability in the asset class is starting to look a little bit more attractive.

Dan Krieter:
All just indications that liquidity has improved, granted from extremely poor levels, to now something more resembling normal. It's not surprising to see spreads narrowing in that environment. But also, another significant contributing factor to the rally in July and early August was likely a pretty significant improvement in corporate fundamentals over that time period. That may come as a bit of a surprise, given what's likely a deterioration in the macro environment in that same timeframe, but fundamentals have improved. I'm not talking about Q2 earnings. Q2 earnings were definitely a mixed bag, very strong for some corporations, pretty weak for others. What's really changed in the last couple weeks has been the expectation for future earnings. We can see this in earnings revision indices. There are a few of them. The one that we use most commonly is just Citi's earnings revision index, which looks at equity analysts' expectations for earnings and looking at the ratio between upgrades to earning expectations and downgrades.

Dan Krieter:
The most recent data we have as of August 5th showed a reading of 0.0, so equivalent upgrades and downgrades. From an absolute perspective, earnings revisions sending mostly neutral flag. But what I want to highlight is the increase we've seen in the earnings revision index in the past four weeks. Specifically, earnings revisions have moved from negative 0.31 all the way up to zero. So that 0.31 increase we saw in a four week span is actually one of the sharpest recoveries in earnings revisions we've seen on record. In fact, since the financial crisis, we've only seen a larger magnitude increase in the ERI two times, and both of those environments can likely be explained away as mostly outlier periods. The first one, of course, was COVID in April to May of 2020, when expectations for earnings fell off a cliff and recovered pretty sharply. Not surprising to see that with the higher magnitude.

Dan Krieter:
The other one, likely also an outlier, came actually in the summer of 2016. In June to July of 2016, where we saw a very short-lived, but quite sharp drop in earnings provisions just after the Brexit vote, which then quickly recovered as the reality sunk in that Brexit was going to be a multi-year thing. Looking back at earnings provisions, since the financial crisis, the other two environments were likely due to outlier type of situations, and we don't have an obvious externality of this time that's driving a significant increase in earnings. It's just been a very, very sharp increase in optimism. I'm not sure if I used the word optimism correctly there. Maybe it's a decrease in pessimism. How are you viewing that, Dan?

Dan Belton:
Yeah well, I think you said it. On an absolute basis, earnings expectations are roughly neutral, and that improvement you talked about really coincided with the end of the second quarter earnings releases. To me, it's more of a relief rally, in the sense that there was a growing fear that earnings were going to suffer at some point in Q2, as they were released in late July, early August. And when it became clear that wouldn't come to pass, that's when we saw that index start to climb from negative numbers towards neutral. What we found is that wasn't going to be a Q2 story.

Dan Krieter:
The question for credit spreads now becomes is the recent improvement in earnings expectations warranted, given the broader macro environment? I think that's what's going to be driving spreads in the weeks ahead. Surely, technicals will play a role. We have the September supply wave coming up in a couple weeks, once we get out of the "dog days of summer". It's likely that September supply is going to be very heavy if August showed us anything with expectations of 70 to 75 billion, getting 115 billion or so shows that there likely is some demand to issue... Typically, we see 150 to 160 billion in September. I think we'll get all of that and possibly more, but it's worth noting that spread just continued narrowing up until just this past week. Also, it's worth saying that September supply is mostly expected. So 150 billion, 160 billion sounds like a ton, but obviously investors are expecting that. While technicals will play a role at the margin, I think what's going to be truly driving spreads is the fundamental picture.

Dan Krieter:
So I'll kick it to you, Dan. What are your thoughts? Are we out of the woods now? Or was this rally in the back of more optimistic expectations for earnings may be a bit premature?

Dan Belton:
Yeah, so first I want to touch on what you said about August supply. I think supply has been a really complex issue as it relates to credit spreads this year. Typically in a vacuum, obviously heavy supply is going to be a headwind on credit spreads. This year, it's not been so simple. I think supply has obviously been driven, especially this year, by the primary market reception that issuers have become accustomed to expect. As sentiment has firmed, that has brought in some supply, which isn't necessarily a headwind in and of itself. Issuers are coming to market to the degree that they think the market is going to handle their supply. I agree that September issuance is generally well set up for, and it's the heaviest month of the year. Investors are well conditioned to expect this supply, and it doesn't typically weigh on spread.

Dan Belton:
So I don't think that's going to be the catalyst here to wider credit spreads. I do think that fundamentals are still likely to turn. We've had a lot of reason for optimism over the past month or so. If you look at the economic data broadly, it's coming a little bit better than expected, if you look at, for instance, an economic surprise index. But over the longer term, and we're on record with this expectation, the Fed is likely to continue to tighten financial conditions over the longer term. This expectation is also underpinned by some of the rating actions that we've seen. While the economic data came in pretty constructive relative to expectations in August, the rating actions have reflected an increased amount of pessimism in the corporate market over the past month.

Dan Belton:
In the corporate market as a whole, downgrades are actually outpacing upgrades for the first time of any month since January of 2021. However, it's worth noting that this has been almost entirely concentrated in the high yield space. Upgrades in investment grade are outpacing downgrades by a ratio of almost three to one. So it's entirely high yield story, where downgrades are outpacing upgrades by a ratio of two to one. But typically downgrades begin in the high yield space and then trickle into investment grades. It could be something of a canary in the coal mine, that we're starting to see some negative rating actions among high yield corporations. It's going to eventually begin to affect high grade credit.

Dan Krieter:
It's interesting just looking at the economy as a whole, incoming economic data continues to indicate slowness ahead, potentially recession, however you want to define it. The index of 15 survey based economic indicators that we've been watching very closer this year continues to come in at nearly the lowest levels since 2010, excluding the pandemic. And we're off to a very poor start in August, with some of the forward looking indicators, housing market data, all showing by design a slowing economy. And just whether or not you believe the Fed is going to be able to drive a soft landing, we remain skeptical of that. You did a good job setting the table for the potential for deterioration and corporate fundamentals. I think the economy's pointing that way.

Dan Krieter:
The last piece of it is just talking about the Fed, which you touched on. I think it's worth talking a bit more about, with Jackson Hole coming up at the end of this week. Because the backbone of our medium to long term more bearish view on credit has been that the Fed is going to remain less accommodative than market participants have grown accustomed to through a slowdown in economic growth going forward. Now, it's worth mentioning that the minutes from the July meeting, which we got last week, maybe cast some doubt on that. For the first time, we saw the Fed talking about concerns of tightening, which could potentially indicate that the Fed will move toward accommodation more quickly than people are expecting. Certainly we'll looking for more clarity on that in the next couple days at Jackson Hole. I guess I'll just ask you Dan, how did you read the minutes? Did it start to change your expectation for the Fed in the medium to long term here?

Dan Belton:
Yeah, I think we were both surprised by the minutes and how dovish they skewed. It's worth knowing that those minutes corresponded to the meeting where many market participants interpreted the Fed as making a dovish pivot. It'll be interesting to see if Powell does double down on that dovish rhetoric, specifically talking about the risks to over tightening. That's going to be what I'm looking for at Friday's speech, but I don't think that the Fed is ready to pivot yet. I think we're going to see talk about the pace of rate increases slowing, which is, as we've talked about in the past, is really a given at this point. They're not going to keep going 75 indefinitely. They might go 75 in September, but then it's almost assured that they're going to start to slow the pace of rate increases. We've moved from a super hawkish Fed where they're going 75 basis points meeting, or at least we're set to move away from that Fed. But I do think that we're going to continue to see Powell embrace a higher Fed funds rate for a longer period of time. We are seeing that generally reflected in the future's market. We're seeing expectations of early 2023 rate cuts really come up. The market's expecting an elevated Fed funds rate to persist well into 2023. I wouldn't be surprised if that's the message that Powell really reiterates on Friday.

Dan Krieter:
Yeah, historically Jackson Hole hasn't been the source of much volatility in the financial markets. I went back and looked at the spread market reaction to the Jackson Hole meetings both the week of and the week following Jackson Hole since the financial crisis. Since 2013, spreads have moved on an average of less than one basis point in the eight sessions following Jackson Hole. This doesn't come as a big surprise. Typically Jackson Hole is more academic in nature, more longer term in nature. It's not generally a place where the Fed communicates near term monetary policy. But that could also be a function of just where we are on the economic cycle, because there are instances where Jackson Hole has served that way. If you look back in 2011 and 2012 to at the time Chairman Bernanke's speeches, the market was extremely focused on whether or not Bernanke would set the table for more accommodation, whether that was via more QE or an operation twist.

Dan Krieter:
And in 2011 and 2012, we did see outsize reactions to Jackson Hole, with spreads moving six to nine basis points from an absolute value perspective in the week following Jackson Hole. Historically it hasn't been a vital environment, but we have seen examples where it has been. I think it could be this time around with the near term direction of monetary policy so uncertain, so any clues the Fed gives us here is going to move the markets. Now heading into Jackson hole, I will note that market participants are clearly expecting a hawkish outcome. That makes sense, just given like I said, the long term nature for the Jackson Hole meetings, we're going to be likely hearing about a central bank fighting inflation for the first time in decades, and what that has meant for monetary policy. But we can also see the expectations for hawkishness coming through SOFR positioning, which showed hedge funds now maintaining their largest net short in three months SOFR futures in the four year history of the data series. And while not as extreme, there is also a similar short built up in Euro dollar futures, to the extent that LIBOR is still an actively traded reference rate there.

Dan Belton:
Then asset managers have also moved from 750,000 contracts long to just over 300,000 contracts long. That's something that we talked about in the past, is something that had led to some narrowing pressure on swap spreads partially reversing.

Dan Krieter:
So clearly then, this sets up for a narrowing in credit spreads if the Fed actually does deliver on dovishness. But we are aligned with the consensus here, that we're expecting the Fed to be more hawkish. While that may not mean near term volatility and credit spreads, or a sharp move wider since it's what the market's expecting, it does move us towards the medium term outlook, which is to continue to expect spreads to drift wider here, within the range likely we're not going to see an outside push to 200 or above that likely. But we are still of the belief that spreads are going to remain elevated for a longer period of time. Even though the peak is lower, the duration of spreads of "elevated levels" will likely be longer than what we've gotten used to seeing, just given the changed Fed reaction function to slowing economic data this time around.

Dan Krieter:
Now Dan, before wrapping up, I do want to shift the conversation to swap spreads very quickly, because we have seen some volatility in swap spreads. Specifically, we've seen some widening across the swap spread curve in recent weeks. Certainly, a part of that has been the change in positioning in SOFR futures for end users. We've talked about that in our written work and in recent podcast episodes, that with the transition to SOFR now, the drivers of swap spreads are more technical in nature. So things like positioning have much more power to change swap spreads than they did maybe before, when we were using a credit sensitive rate such as LIBOR. The move net short from hedge funds and the move shorter from asset managers, that influences swap spreads wider. But we've also seen some chatter recently about a potential change to SLR calculations, which would be a widener as well, which was specifically on display potentially in yesterday's market.

Dan Belton:
Yeah, so just as a bit of background, the SLR exemption was put in place around the onset of COVID. And the Fed allowed the GSIB banks to exclude reserves and Treasuries from their SLR calculation, which just enabled them to hold more reserves and hold more Treasuries, which at the time made sense as the Fed was pumping more liquidity into the banking system. Now this was a very popular topic in the beginning of 2021, when that exemption was set to expire. There was a lot of uncertainty over whether the Fed would ultimately allow it to expire, and somewhat surprisingly they did. At the end of the first quarter of last year, that exemption expired. So Treasuries and reserves were again included in the SLR exemption, which theoretically, and probably in practice, made it more expensive for the large banks to hold these massive portfolios of Treasuries. Now, Treasury intermediation has become a very, very important issue for this Fed, and Powell has mentioned his desire to potentially introduce a longer term permanent tweak to the SLR. Although that was largely put on hold while the Fed was waiting to appoint a new Vice Chair of Supervision. Recently, Michael Barr took that post, and so now this is really an issue back on the table. It's important to note that we haven't gotten any official messaging or guidance on this topic, but market chatter seems to have really picked up around it.

Dan Krieter:
Yeah. We're ultimately expecting the Fed to deliver SOR exemption. It seems to be something that the Fed will need in order to ensure functioning of monetary policy in an ample reserve regime, which it seems like we're going to be in, I won't say forever, but at least for the foreseeable future. So we're expecting that at some point. The question is, what will it actually mean for swap spreads? Because if you look at what the banks has actually done, we wrote a piece back in 2021 estimating that banks could sell as much as $200 billion of Treasuries after the exemption expired. That hasn't happened at all. In fact, banks have added over 200 billion in Treasury positions since then. How were we so wrong? The explanation for that is we were expecting banks to want to maintain a pretty sizable SLR buffer above 5% minimums.

Dan Krieter:
Our analysis that estimated as much as $200 billion worth of selling of Treasuries was based on banks moving their SLRs back to the 6 to 6.5% range where they've been even prior to the pandemic. What we've seen in actuality is banks have just operated a much, much lower SLR. Aggregate SLRs for most of the GSIBs now are between 5.3 and 5.6%, much lower than they were prior to the pandemic, and lower than the thought banks would be comfortable operating at. We can interpret this two different ways. Potentially, banks are just... There's been a change in behavior and banks are just more comfortable at lower SLRs at this point. Or, maybe banks are expecting an SLR tweak, and that's sort of what I think is the case. Banks know that they're going to have ans SLR exemption at some point.

Dan Krieter:
But whether or not that's true, low SLRs ahead of an exemption means that the behavior for banks won't change. We're not likely to see a massive increase in bank Treasury holdings as a result of SLRs. In fact, the mix between reserves and Treasuries on GSIB balance sheets is now more heavily tipped towards Treasuries than it was even during 2019, when reserves became scarce. That's clearly not a concern now, given the abundant reserves in the system, but just goes to show the point that banks already own a very high amount of Treasuries. And that's unlikely to change, except for maybe via QT. But if that's the case, if banks are taking down a ton of Treasuries as a result of QT, that's not going to be a widening swap spread environment.

Dan Krieter:
A long winded way of saying that yes, with chatter and potentially delivery of SLR, we should see some pop in swap spreads just due to superior Treasury market functioning. Maybe that's why you saw long end spreads perform yesterday. That's where Treasury market liquidity is potentially not as strong as compared to the short end of the curb. But long term, we wouldn't expect SLR to have a major widening influence on swap swaps, which leads to our recommendation. Be looking to take profits or set shorts in swap spreads here, particularly with QT now really starting to get underway.

Dan Belton:
One final note on a potential SLR exemption, as it relates to credit spreads. We think that would likely be a positive for credit spreads for a couple reasons. First, financials specifically are likely to have balance sheet space freed up in order to invest in higher yielding assets. It's probably fundamentally a credit positive event for financial specifically. Also, if you allow banks to take on more Treasuries, it has a sort of minor impact of the portfolio balance channel, much like quantitative easing had, in that if banks are more prone to take on Treasuries, it could force the marginal investor out the credit curve, putting downward pressure on credit spreads generally.

Dan Krieter:
Yeah, at the margin that's a good point, Dan. I would just say QT will certainly work the opposite way and will probably be of a larger magnitude than the SLR. But it's a good point worth keeping in mind, particularly if the Fed isn't able to get its balance sheet as low as perhaps it wants to. Well Dan, I think we're already on the longer side of our typical episode length here, so we can wrap it up here, unless you have anything else to add.

Dan Belton:
No, 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 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, its 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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