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Making the Case: April 2022 - High Quality Credit Spreads

FICC Podcasts April 27, 2022
FICC Podcasts April 27, 2022

 

Dan Krieter and Dan Belton debate the case for wider and narrower credit spreads. Topics include the evolution of Q1 earnings, technicals and new deal reception, and the likely path of economic demand.


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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 April 27th: Making the Case. I'm your host, Dan Krieter here with Dan Belton as we debate the path of credit spreads in the next couple months covering topics, including fundamentals, technicals, as well as the macro environment.

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.

Dan Krieter:

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.

Announcer:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Dan Krieter:

Well, then it's been quite volatile week since our last podcast reporting, particularly in the Treasury space where we're seeing seemingly wild intraday swings with Treasuries being unable to really decide what direction they're going to go. We see the short end rallying 15 basis points in a day, backing up. It's been a different day, a different market every single day, but that really hasn't been the case so much in credit.

Dan Belton:

Yeah, well, we're basically just on this straight line wider in credit spreads now. So we are off 21 basis points in the past three weeks and that comes after a three-week narrowing of 37 basis points from those peaks that we saw in the middle of March as the Russia-Ukraine headlines have seemingly taken a backseat to the market narrative, which has focused more on the Fed and the implications for rate hikes on the real economy. And really just how much Fed tightening the economy can withstand here. So we're about 13 basis points from the highs that we saw earlier this year and it's been a really relentless risk-off tone in credit recently.

Dan Krieter:

Yeah, and we can caveat the year to date range by saying that the actual peaks and spreads were somewhat influenced by Russian debt in the index that was then removed at the end of March. So I think I just want to say that because high level, we're getting pretty close to the top of the range. I mean, even just including the actual path of spreads, I think we've only closed wider on the index nine sessions year to date than where we are right now. And then if you include the Russian factor, it might be even less than that.

Dan Krieter:

So we're getting pretty close to the top of the range and this mostly fits in line with the view that we've expressed on credit for the majority of the year. We thought that we'd see a significant widening Q1. We got that, which would then give way to more range-bound trading in Q2 and that's sort of been true. It's been a wide range, certainly wider than we expected. But it's been confined to the year to date range, at least.

Dan Krieter:

So with today's episode, I want to go back to a format we've done a few times in the past. We call it making the case where one of us sort of presents the case for why now is a good time to look at putting on some trades in credit, while the other one will argue the opposite that we should continue to wait and it spreads will likely continue to widen here in the near-term. I think it's a good format for today's episode for a couple reasons. First, just given where we are with spreads approaching the top of the range, we're reaching a potential inflection point where that range might hold and spreads can stabilize and snap back a little bit. Or will we continue to widen through and looking for a new range?

Dan Krieter:

And second, because this will be our last edition in the high-quality spread space for Macro Horizons likely until June because my good friend here Danny is welcoming his first child. I should say children, it's twins due on Monday. So heartfelt congratulations and best of luck to Danny here. His life is certainly about to change.

Dan Krieter:

My life, unfortunately, will not. I will be here writing strategy the entire time he's out on paternity leave, but he'll be going on for May. So since this will be our last episode for a while, I think something with a bit longer view, maybe more shelf life would be appropriate. And so I think we should make the case. And I'll start by asking you the question, which side would you like to argue?

Dan Belton:

I will as we have with this format many times before, I'll argue the case for putting some trades in credit and positioning for credit spreads to either narrow or remain around these levels for the near-term.

Dan Krieter:

All right, then I will be left with the case for wider. And I guess I can start with the case for wider just on the growing fears that's prevalent to market right now, which is the growth fears. I'd say over the past week or so, the market has certainly refocused on the growth aspect of things. We haven't heard as much chatter on inflation. We certainly haven't heard as much on Russia-Ukraine. It's growing fears that the economy won't be strong enough to withstand the degree of Fed hawkishness that we're going to be getting starting in may with what's expected to be a 50 B hike.

Dan Krieter:

The risk apparently is higher than that. I think it's pretty well accepted it'll be 50 though, as well as the announcement of balance sheet normalization. And so just to put maybe a bit of an exclamation point on the gross concerns a couple days ago, I pulled together all the major survey-based data indices that we track that includes ISA manufacturing, as well as the major regional surveys, empire manufacturing, Philly Fed, et cetera, et cetera, as well as the confidence metrics, the University of Michigan Conference Board Conference, all that.

Dan Krieter:

And I got 12 major indices and I pulled them back historically to the global financial crisis and basically averaged them. They're all of similar magnitude. They all work the same way, just above 50 is good, below 50 is bad, blah, blah, blah. And just to look at the evolution of those data series and I found two major takeaways. The first one being that this amalgamation of survey-based economic indices was a strong predictor of GDP. That shouldn't be very surprising, of course, but you want to least see that the index is showing what we want it to show, which is that these survey-based metrics, which are meant to be leading economic indicators are actually a good indicator of the future and they are.

Dan Krieter:

The other takeaway I got from the little study was that they're pointing to some potentially significant growth headwinds in the months ahead, specifically the index of aggregated survey-based metrics that I was looking at is currently as of March data release, since we don't have all April data yet at the lowest point since 2016. I got an average of 54, which is we haven't seen that since 2016 outside of the severe dropped during the pandemic that was very short-lived.

Dan Krieter:

And perhaps most importantly, that index only got to 50 or below three times since the financial crisis, twice during the 2010 to 2013 environment where we saw the European debt crisis, as well as a very slow economic recovery coming out of '08, '09 and then in the pandemic in 2020. And I will just make the very obvious distinction here that in all three of those environments, the Fed was in full on accommodative mode and was expanding their balance sheet through various rounds of quantitative easing.

Dan Krieter:

Whereas in the current environment, we're in basically the polar opposite. So we're seeing growth concerns. That's certainly so something to keep an eye on by itself, but then also the additive impact of restrictive Fed policy going forward they'll only serve to further away on the prospect of growth. So, I mean, I think the case for wider starts really here that I think growth concerns could grow significantly worse in the month ahead.

Dan Belton:

Yeah, I think it's no secret that we are in a slowing growth environment, but I don't think we're in an environment where a recession is imminent. I think most models you look at would say that a recession is more likely in 2023 or 2024. And even a slower growth environment while it's not the most constructive environment for credit spreads, I think that even the backup we've seen it could make sense to put cash to work here. Just given that the impact of Fed rate hikes that are set to come later this year are not going to really materially impact the growth environment until later this year.

Dan Belton:

And then if you take a look at corporate fundamentals, those are certainly moderating from the real strengths that we saw in 2021. But they're not yet at any point of outright weakness. When you look at the balance sheet fundamentals that have come in this quarter, they've actually surprised at least from where I'm sitting to the upside. If you look at metrics like interest coverage or net leverage, we actually seen those are flat or slightly more constructive for credit. Corporations have lowered their cash holdings so that's consistent with the rising rate environment.And profit margins have actually been pretty stable from the fourth quarter of last year.

Dan Belton:

And so I agree that these are starting to slip and they're going to continue to slip in terms of the balance sheet, credit worthiness of corporations. But I don't think that's going to be a problem in the near-term. And then the other point I would make about the slowing growth environment is that it's something of a double-edged sword. As we start see more macroeconomic weakness, we are going to start to see some of these Fed rate hikes that are priced in start to come off a little bit. That's not a net positive for credit spreads, but it should mitigate some of that negativity that we're seeing with respect to the lower growth outlook.

Dan Belton:

And so my case for narrower credit spreads or at least my case for initiating some long positions in credit spreads is that given the backup we've seen, we have break-even spreads more attractive than they've been since 2020. We have all-in yields more attractive for foreign investors that they've been since really 2016. I think there's a little bit more of a cushion built in now for some at least tactical narrowing positions here given that we're near the top of the range like you mentioned.

Dan Krieter:

I'll make the counterpoint to that by saying you mentioned recession odds not being likely in 2022 and I agree with that. I don't think we're going to see a recession in 2022, but I will say that the one most remarkable aspect of this economic cycle, the pandemic has been the speed with which everything has happened. Everything has happened much quicker than we and anyone in the market thought would happen. And so not a lot of science behind this obviously. But if a recession happens faster than people expect, than the models expect, I'm not going to be shocked by that.

Dan Krieter:

I take your point and agree with it that that the impact of Fed monetary policy at least on consumption, that shouldn't be felt for months, but what if consumption's just going to drop on its own? We've talked a lot about the savings that people had accumulated during the pandemic and that our estimates for the exhaustion of that savings was going to happen around the middle of the year. We're seeing some indications that it's happening.

Dan Krieter:

The labor force participate continues to rise back to near pre-pandemic levels here as people go back to work no longer living off their savings. So it's not for sure certainly, but there's a very good chance consumption will slow even agnostic to the Fed policy. And we could find ourselves in something close to a recession much quicker than people of thought given the speed that this economic cycle has played out.

Dan Belton:

So I think consumer strength is actually one of the bright points right now for the economy. I think if you look at the big bank CEOs and what they were talking about during their earnings calls, they really emphasized that the consumer's in a good place, the consumer has money. They're paying off what little debts that they have outstanding. And these are people who have insight into directly checking and savings accounts. So I put a lot of weight into those comments.

Dan Belton:

And from what I can tell, the consumer is still on solid footing. I think the increase in the part rate is something that is probably healthy as the economy moves away from the stimulus-fueled environment of the post-pandemic world and into a more new normal environment where consumers should be returning to the workforce at least prime working age adults.

Dan Krieter:

Yeah. From an economic perspective, I agree. The color we're getting out of Q1 earnings calls have been frankly better than I expected it to be, but I'll just make the observation that Q1 was always expected to be strong. And so Q1 is strong. I'm not going to change my view entirely because Q1 is looking maybe a little stronger than we expected. We always expected it to be strong.

Dan Krieter:

The lagging economic indicators are going to be looking very good. And yes, the part rate increasing that is in line with a healthy recovery. We should be seeing people returning to the workforce and we are. Just the view forward from here. And you can see it both in the survey-based economic indicators I talked about, but also micro data, data on shipping. We've seen transportation rates and volume start to drop pretty significantly, inventory's looking relatively high even this morning.

Dan Krieter:

It's all painting a picture here that things could slow meaningfully. And I don't want to keep harping on the same point. I am going a different direction here. Whether or not you agree with my fears that growth could slow very rapidly in the late second quarter, early third quarter of this year. I think you have to acknowledge the fact that there is a risk that it will happen. And my main thing with credit right now is I don't think you're being compensated for that risk. Just looking at credit spreads relative to Treasuries. I mean, that's a great way to look at credit spreads. What is the yield advantage I'm getting for taking the risk of corporate credit here?

Dan Krieter:

And if you look at that metric historically, I would argue that we should be at average levels compared to Treasuries, if not, probably a little bit wider just reflective of all the risks facing the economy. Not just from the growth perspective, but also inflation, also geopolitical risks with there still being an active war right now. And instead of above average, we're getting well below average percentage of Treasury yield enhancement from corporate credit. I can't square that with where we're at right now from an economic perspective.

Dan Belton:

So I think we're not really that far apart on this. I agree that higher Treasury yields generally over a longer period of time warrant wider credit spreads. I just think that's generally more of a long-term dynamic and I don't think we're going to get that here. And so we're mostly in agreement that over the longer-term we are going to see wider credit spreads at least as long as this stagflation scenario continues to play out in the market. But in the near-term, I think there's other reasons to expect that spreads can hang in around these levels here.

Dan Belton:

I think if you look at technicals, we're heading into summer months when supply is typically pretty light and we're going to start to see, I think new issue concessions start to move lower. We're going to see some demand for new supply here that could also bring lower volatility for the market more broadly, especially as the likely path of Fed policy becomes more clear, especially after next week's FOMC meeting. I'm not expecting a significant surprise next week from the Fed, just given what they have to announce. They're set to announce a 50 basis point hike. There's set to announce balance sheet normalization.

Dan Belton:

They've telegraphed these things and I don't expect much more of a surprise here. They might telegraph another 50 basis point hike is likely in June, but once we have some more clarity from the Fed that could certainly result in less volatility, which is unambiguously a good thing for credit spreads. We could see some stability here just at least in the near-term as we head into the summer months.

Dan Belton:

Now, will we see weakness after that? I think it's possible. I'm less convinced than you are that we're going to see broad economic weakness, I agree. You mentioned the weakness in shipping and that certainly has garnered a lot of headlines recently, but I don't think that necessarily means that a recession is imminent. So over the long-term, I think the next significant move for credit spreads is wider, but I think range is going to hold for the next several months. And for that reason, I like putting it on some long positions in credit.

Dan Krieter:

Okay. So then let's, I guess, narrow the timeframe here. If we are in agreement that it's going to be in the longer-term likely wider spreads, then we'll contain our conversation to just the next three-month period. You mentioned technicals. I'm with you that supply will fall into the summer months, but at least through the end of May, we should see still strong issue in fully liquid markets here. And I haven't seen much reason to think the concessions are going to drop meaningfully from here.

Dan Krieter:

I mean, even just looking at yesterday's deal performance, I think in The Daily this morning we characterized it as one of the worst days in the primary market this year. We had a drop, only the second drop of the year. We had to deal price at IPTs implying concessions of 20 basis points or more. And it just seems to me that it's baked into expectations now from investors that if you're coming to market, you're going to pay not super elevated concessions, but you're going to be paying some concessions here. And so it becomes a function of how much supply are we going to get.

Dan Krieter:

I'm sympathetic to the notion that given where we are at all-in yields now, we could see the pace of supplies start to drop off a bit. Certainly anything from a refinancing perspective, I'm not going to say it's unattractive at this point, but it's certainly not super attractive. But you could make the argument the other way here that if we're expecting spreads to go wider and potentially Treasury yields, I don't know at the long end. Maybe we've seen the peaks there, but there's certainly got to be some fears that long end Treasury yields will go up as well.

Dan Krieter:

Even at relatively unattractive yields for borrowers at this point, I could see a scenario where issuance stays pretty strong based off the perception that it will only get worse from here, and that will continue to influence concessions higher.

Dan Belton:

I think that's possible. I think we've already seen a lot of that pre-funding I think just anecdotally in discussions with issuers that we've had. It seems like there's been a push to pull forward borrowing plans and I'm expecting the second half of the year to bring lighter issuance. Now, does that mean that we start to see that in May? I'm not sure. Maybe, maybe not, but I do think that we've seen the bulk of at least the pace of heavy supply in 2022. And it's likely to turn lower in the later part of this year.

Dan Belton:

May is typically a fairly heavy month for issuance, but investors usually set up for heavy supply when it's calendar-based like that. And then to your point about yesterday's deals, I think that was unique scenario. We had risk assets move sharply lower. After the deals were announced, we had CDX finish the session five and a half basis points wider. It could be viewed as a testament to the strong demand out there that index spreads only finished the day a basis point are less wider.

Dan Krieter:

So you bring up demand and that's another point that I can talk about from a potential case for widening here. And that's the path of demand, particularly from asset managers here we've seen more consistent outflows and inflows into corporate credit recently. And now we're starting balance sheet normalization, which I can only imagine will continue to pull money away from higher beta sectors, such as corporate credit.

Dan Krieter:

Now that's something that's going to play out over the long-term. Obviously, it's more of a mechanic move with balance sheet normalization, but outflows could certainly continue to amount potentially with increasing rapidness alongside balance sheet normalization here in the months ahead.

Dan Belton:

On the other hand, though, if you look at the spread between the equity earnings yields of the S&P 500 and the IG Index yield, that spread is at the narrowest it's been since really the financial crisis implying a fairly attractive RV profile for corporate credit right now.

Dan Belton:

So I actually think that demand should be fairly well anchored here. As balance sheet normalization starts, corporate credit isn't really a high beta sector. You could view that as a fairly defensive opportunity for investors who are looking to add some yield over Treasuries.

Dan Krieter:

Yeah, that's a good point. I may look at corporate credit as a high beta sector sitting where I am in fixed income. Certainly from a broader financial market perspective it is not. And your point on earnings yield versus yield on corporate bonds is really an interesting one. And one that I would normally say, "Wow, that's pretty important point," but I've always struggled with that relationship because it should be a relatively strong driver. But looking back over the long-term and I'm talking back decades here, it just hasn't been.

Dan Krieter:

Actually, and the relationship between those two data series we've seen what's more akin to like regime shifts, where we'll see earnings yields significantly below bond yields. At some times it's significant the above bond yields. At other times and I've never really been able to figure out why that is. I mean, in my head, it seems like credit yield should essentially always be higher than earning yields. I mean, looking at the capital structural of a corporation, if you own either the debt or the equity, you're taking the same credit risk.

Dan Krieter:

If the corporation goes bankrupt, you're going to lose your money on both the equity and the bond. I guess with the bond, you get some recovery through the default process, whatever. But let's just say in a default, both equity holders and bond holders lose. So then in terms of turn, with a bond yield you get your par back. With dividends, you earn the dividends and then also you have the upward appreciation of the price of the stock.

Dan Krieter:

So with bond yields, it seems like you'd need to get more yield in order to compensate for the loss of price appreciation potential. But, of course, the other side of that coin is obviously the textbook relationship is that bond yield should be lower because you're higher in the capital structure. I get that. So I see arguments in both directions that make me not really sure which way the relationship should go. And then looking historically, I don't see a clear relationship. So to me, well, it should be a driver. I just don't see it.

Dan Belton:

Well, you talked about the price appreciation in equities. You also have the downside risk to that where you could lose your principal more easily than you would in a corporate bond. So from that standpoint, equities are a riskier asset and therefore they should demand a higher yield than corporate credit should.

Dan Krieter:

I mean, that's a great point. So I think here we've actively demonstrated that there's really two sides of that coin between equity and bond yields that makes it very difficult for us to really take any direction from the relationship with those things. It's certainly a very interesting discussion that certainly comes up frequently. It seems like it comes up a couple times every year, but I've just never found anything in that relationship that makes me really take any meaningful conclusions from it.

Dan Krieter:

So we've been talking about this for a while now, so I think maybe we can wrap it up with maybe one final closing argument, if you will. And my closing argument on the case for wider is simply this. The all-in yield on say in an investment rate in corporate right now, say in the 10-year space is near highs that we've seen in the past decade. It's been higher, but we're within shouting range of the highs experience at various times throughout the cycle.

Dan Krieter:

So there's a pretty compelling argument to be made that we're already in somewhat restrictive territory for financial conditions. And any further increase in yields or spreads is going to be only further restrictive. And I don't know that the market has fully priced the impact of tighter financial conditions on the corporate market. Every time in the past decade-plus since the financial crisis that we've seen financial conditions get tight, the Fed has rode to the rescue and soothed markets. And that isn't going to happen this time.

Dan Krieter:

And so I think in the near-term in the next couple months, growth concerns are only going to continue to mount. Yes, we're not going to go into recession, for sure not in the next couple months. But we're going to see growth concerns continued to mount, financial conditions are going to continue to tighten and the market is going to more fully appreciate the risk embedded in credit markets, particularly in the high yield space in the next couple months alongside growing growth and spreads could widen meaningfully, I believe.

Dan Krieter:

And I don't see a compelling case for me that spreads are going to move meaningfully and narrower. I'll rest my case here and now give you the floor for your closing argument.

Dan Belton:

So given the backup we have had in spreads and in yields like you mentioned, the all-in yield on corporates is near the highest it's been over the past decade. That offers a fairly compelling relative value picture at least for investors willing to take some tactical long positions. I expect the range to hold absent, more clarity that either the Fed is going to act more hawkishly than is already priced or that the consumer or corporations are starting to show indications of an imminent recession.

Dan Belton:

I don't expect either of those things to happen in the next few months. So I think playing the range is going to be a dominant theme over the next few months. And if you believe that and if you believe that the range is in for the medium-term, now is probably a good time to initiate some long positions.

Dan Belton:

The last thing I'll say is that there's been a lot of Fed priced in and I don't think the Fed is going to move to outright easing if more evidence of weakness starts to materialize, but we start to see the pricing out of some of these Fed rate hikes in the next few months. And that would be not the Fed riding to the rescue, but it would be relative soothing of markets if we start to have rate hikes be priced out here.

Dan Krieter:

All right, pretty compelling closing argument. You almost swayed me to your side, almost. I think we can wrap it up there. We'd love to hear from any of you listeners, the jury in this Making the Case, see which side you are more swayed by. Otherwise, we'll be back in June and I wish Danny nothing but the best of luck and congratulations in advance for this really awesome moment in his life. Thanks for listening.

Dan Belton:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton, B-E-L-T-O-N@.bmo.com.

Dan Belton:

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 in BMO's Marketing Team. This show has been edited and produced by Puddle Creative.

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

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