New Normalization - High Quality Credit Spreads

Dan Krieter:                                           Hello, and welcome to Macro Horizons high quality spreads through the week of April 20th, new normalization. I'm your host, Dan Krieter here with Dan Belton as we discuss recent price action in spread markets. Then in the focus of today's episode, we talk about the Fed's plan for balance sheet normalization, whether or not they'll eventually sell and what it means for credit and swap spreads.
                                                       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@bmo.com. We value and greatly appreciate your input.

Speaker 2:                                             The views expressed here at are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries.

Dan Krieter:                                           Well, then only a couple trading sessions since our last podcast with the holiday impact of Easter holidays, half-day and a full close in the US Thursday, Friday, and then Europe was out on Monday. So not a ton of time for spreads to move, but I think we've seen them leaking a bit wider.

Dan Belton:                                            Yeah. After touching as low as 115 basis points two weeks ago, we're about 13 basis points wider now. So a decent size move here. We're now closer to the top of the year-to-date trading range, which is about 54 basis points wide. We're at 128 in the ice B of the corporate index. And I think what's most interesting about the recent price action and spreads is that we're seeing credit trade without a real fundamental impetus. We've seen a breakdown in the correlation between daily excess returns to credit and S&P 500 returns. And it seems like there's not a lot of conviction and recent trading after peaking in the middle of March, we were kind of scratching our heads about why spreads had performed so well. And now that they're leaking wider, it makes a little bit more fundamental sense to us, but there doesn't seem to be a ton of conviction in the market.

Dan Krieter:                                           Yeah. And somewhere right in the middle of range and this fits well with the view we were talking about really all year expecting a material widening in Q1 and credit spreads. And then for Q2 to be typified by more range-bound trading while investors just wait for incoming economic data. And it's probably the rally went a little bit too far a few weeks ago. I called it the FOMO rally. I just think people are just looking to put cash to work at wider spreads, higher yields, and it got a bit overdone. And so now we're like you said, lack of conviction. We're just going to be drifting in this range waiting for more economic to data. So it makes sense. I mean, certainly, the range has been wider than we thought, but it seems to be consolidating now and I think that's going to continue.
                                                       And on that economic data front, we really need to see more evidence of, well, two things, one, how the consumer's holding up, and two, inflation and whether or not that's going to continue falling after last week's slightly more encouraging number on core and month over month. So it's going to take months of that to come into focus. But with the arrival of Q1 earnings releases, we are getting some glimpses here, at least on the growth side. And from what we've seen so far, it's been mostly encouraging.

Dan Belton:                                            So most of the large US banks have reported earnings already. And the headline takeaways, at least from a macro perspective, what I took away was that the strength of the consumer is not really in any doubt, at least at this point in the cycle. You had a lot of the big CEOs talk about how the consumer is sitting on a lot of cash right now, paying off their credit cards, paying off their mortgages, and really has a lot of pent-up savings still from the pandemic. And so we've been focusing a lot on that topic on how much does the consumer have left from this pandemic induced savings? And it seems like that's not an issue at least at this point in the cycle. Another factor that I think is worth talking about with respect to the macro environment, with an increase in loan loss provisions from the big banks, and there is an emphasis that there isn't a real credit concern right now with bank loan portfolios. But these loan loss provisions were really just a nod to the macro and policy uncertainty that's facing the market right now.

Dan Krieter:                                           Yeah, certainly, the increase in loan loss reserves is notable, but I agree the headline has to be that it appears that consumer remains on solid footing. Now, anyone who follows our work closely knows that's something monitoring very closely and coming into the year, we were on alert for the consumer's starting to roll over a little bit towards the middle of the year. And it appears at least in these Q1 earnings that has not begun yet. Now, we'll caveat this by saying that this is Q1. We always expected Q1 to be very strong on the consumption side. But even having said that, I think that these numbers are better than I was expecting at this point.
                                                       So certainly, the jury's still out here, but the odds of a soft landing, at least in our view are increasing here, but it's going to take more time. And while we're waiting, I think spreads just will continue to drift around in this range where technicals are going to be a very strong driver of just the week-to-week or day-to-day performance of credit. And so maybe it's worth talking about technicals herein the past couple of weeks just very briefly. We have seen the traditional post-earnings release wave of financial supply and how's that been going?

Dan Belton:                                            Yeah. So financials have come to the market. We've had four of the biggest six banks price this week. Continued heavy financial supply really continued heavy supply in general. You know, we've had a significant uptick in new issue concessions. Now new issues are really coming at about 10 basis points of concession on average and that's been going on for the better part of the last two or three months or so. And I think that's just really indicative of the uncertainty and lack of conviction and credit markets. So it's likely that's going to maybe improve a little bit from an issue and standpoint, but it should remain elevated at least compared to where concessions were setting for most of last year. In that context, I think overall, bank supply was pretty well received this week. We have more financial issues in the market today, but investors do typically anticipate and set up for this bank supply, and we've definitely seen that happen this week.

Dan Krieter:                                           One thing that struck me in the concession data, at least from the past week, is that we've actually seen concessions for financials coming in lower than non-financial, which is a departure from the trend of really most of the past year, given just the very heavy financial supply. What do you make of that?

Dan Belton:                                            It's interesting. There's a few different components to that. I think, like I said, investors are setting up for and anticipating the supply. And I think part of that includes maybe some weakness in secondary spreads before this issuance comes, which I guess optically results in lower concessions if the comps have cheapened in their days and weeks up to this supply. I don't make too much of it at this point. But yeah, it is an interesting development that we've noticed.

Dan Krieter:                                           Something to just keep an eye on, obviously, it's not quite a trend yet to write a full treat about, but something to keep an eye on, just if it is indicative of any change in investor behavior. So something to monitor there, then I guess I'll just spend a quick second talking about SSA primary marks as we have had a return of issuance in the SSA market. And we have seen some modicum of widening just leaking wider and SSA spreads along said the return of supply. This week, we had an ADB dual tranche and a Canada three-year that both came with IPTs relatively wide or at least wider than SSA investors have come to expect. And there was some narrowing there, but they did retain at least some of that new issue concession. Now, today, the headliner is KfW in the market with the first five year from a tier-one supernational since January, which is really remarkable considering that the five year has been such a popular tenor for so many years.
                                                       It does seem like this deal is going to garner pretty strong demand, especially since it's coming with pretty attractive new issue concessions, a six to seven basis points for a KfW five year, certainly seems like it will be a blowout. I'm setting the over-under for the book size of this one at 11 billion. And we'll see how much the borrower narrows from IPTs. I think the steel might go a long way to determining how we should expect SSA new issue concessions to go in the weeks ahead and what that means for secondary spreads obviously as well. So keeping an eye on technicals, expecting spreads to remain range-bound, while awaiting more signs of growth. You don't think that the Netflix drop in subscriptions as consumers bating down the hatches here, Dan?

Dan Belton:                                            Could be interpreted as the opposite or reversal of what we saw two years ago, but we are far from equity strategists.

Dan Krieter:                                           Yeah, no joking there, obviously. So I think that pretty much wraps up what we've taken away in the past couple days since our last podcast. And really with the rest of the time, I like to focus on the topic we haven't had the opportunity to focus on yet, at least in audio form here, which is balance sheet normalization. We got the details on the Fed's balance sheet normalization at the Minutes from the March meeting and a couple of big questions to talk about on the back of that. But first, as a quick refresher, why don't you just go through what we found out in the Minutes?

Dan Belton:                                            So the Fed's balance sheet normalization caps, which we were expecting they were going to adopt similar to what they did in 2017 through 2019. The caps are going to max out at 60 billion in Treasuries and 35 billion in MBS. What was unexpected is how quickly they're going to ramp up to those maximum caps. They're just going to do it in three months. Assuming that it's announced in May, these maximum caps will be achieved in July. So that's somewhat of a surprise, but in the big picture, I don't think it changes the overall trajectory of balance sheet normalization. We were expecting 60 billion and 30 billion. So 1635 is not too much of a miss from what we were expecting.

Dan Krieter:                                           You're right. Obviously, the caps being so high to begin with comes as a bit of surprise, but like you said, in the long term, looking at how big the numbers are, long term it's not going to really make much of a difference. The terminal size was pretty close. And I think now we can focus on really the two big questions arising from balance sheet normalization. And one is, will the Fed sell mortgages and/or Treasuries? And two, what will the impact be? So let's deal with those two questions sequentially. The topic of whether or not to sell is certainly a hot button topic for investors at this point. And the Fed gave us some guidance in the Minutes when they said that selling of mortgage-backed securities would be considered by the Federal reserves at some point. After QT was well underway, I believe was the exact wording. And well underway says to me that if we're going to get balance sheet runoff beginning in May, well underway would be what? A period of at least three months, probably closer to six months.
                                                       So if we're looking for the Fed to potentially start selling mortgages, it's probably coming later in the year. But I guess my question would be, I mean, we know the Fed wants to normalize the portfolio in terms of asset composition. We know they want to get more towards Treasuries and away from mortgages. So that is a motivating factor for sure. But more broadly, is the potential for selling mortgage-backed securities away for the Fed to be more hawkish and remove more reserves from the system, or is it just a recognition that prepays are likely to slow down very is significantly in the months ahead, given the move and Treasury rates and mortgage rates and the likelihood that the Fed's mortgage caps are not going to be hit? So we're we talking about the Fed just selling to get to its caps and if so, does it really matter?

Dan Belton:                                            Yeah, so I think that's the important distinction here. So BMO's mortgage strategy desk estimates that the average runoff pace of the Fed's MBS portfolio would be around 30 billion a month. So if we're talking about the Fed just selling up to 35 billion to those caps, I think this is largely a non-story. That would mean that in some months the Fed is selling between call it zero and 10 billion in mortgages. And other months when the caps are being reached, they're not selling don't think that's that much of an issue. If their maximum MBS runoff is just going to be 35 billion, whether it's through selling or through prepays maturities, what have you.
                                                       To your other point, if this is a way for the Fed to be more hawkish, and that would be something that is more data-dependent, if they decide that they need to increase the pace of balance sheet normalization, and they do that by actively selling MBS to the tune of greater than 35 billion a month, then that's the more important issue. And I don't think that would come before maybe the fourth quarter of this year at the earliest. And that would only come if we saw a greater need for the Fed to be hawkish and for the Fed to really increase the pace of normalization because of elevated inflation and because financial conditions are just remaining too loose.

Dan Krieter:                                           I have two observations to react to that. The first one being, and this hawkens back to what our boss Margaret Kerryn says a lot of the time. We've never seen a mortgage market where either the Fed wasn't buying or Fanny and Freddie weren't buying mortgages to support the market. I mean, in general, obviously, 2017, 2019 mortgages were running off, but the general idea is Fanny and Freddie were big buyers of mortgage-backed securities prior to the financial crisis. As those retain mortgage portfolios were wound down following the conservatorship, the Fed came in and has been buying mortgages more often than not since the financial crisis. So there is at least some uncertainty surrounding how the mortgage market would absorb that additional supply. We've never really seen the market support itself without that large buyer. I mean, it's probably not coincidental that during 2017, 2019 mortgage spreads wide and pretty significantly compared to other high-quality paper.
                                                       So there is probably a factor there that would give the Fed more pause. But if they do decide to start selling mortgages and above the 35 billion dollar a month cap, as a way to be more hawkish and combat in this scenario, inflation, that's still running rampant, that puts selling Treasuries on the table. So let's talk a bit about selling Treasuries because I know that's something that a lot of clients have been to talking about. It's been president every single one of my meetings the past couple of weeks. And so let's talk that through.
                                                       I mean, obviously, if they were to sell Treasuries, we're looking at runaway inflation here because I mean, if they're going to start potentially selling mortgages no earlier than late Q3, probably Q4 of 2022, selling of Treasuries is probably a measure of months after that. So hard to think this isn't a 2023 story at the earliest, maybe mid-2023. So that's inflation now being sustained for at least another year. I guess let's start here. Do they even need to sell Treasuries or can they just raise the caps or remove the caps? And that is in effect going to give them the additional runoff that they're looking for.

Dan Belton:                                            Yeah. It's just going to depend on how aggressively they think they need to reign in financial conditions. I think if they remove the cap, that's probably only going to give them a marginal increase in average, monthly runoff, above that 60 billion. If they decide they need to go much more aggressively than that, I wouldn't say that's selling Treasuries is off the table. I think it's probably a significant step further than selling MBS because they are of the view that their normal portfolio doesn't contain MBS. It does contain Treasuries. So to me, it's just an extra step past the selling of mortgages. I think selling mortgages is probably going to happen just given that the Fed mentioned it in the Minutes, selling Treasuries would require, like you said, inflation to be really this runaway train where they need to more aggressively reign in financial conditions. And like you said, probably more of a 2023 story. It's not in my base case, but you can't take it off the table.

Dan Krieter:                                           Yeah. That's sort of where I fall. I mean, every time I get asked this question, I always bring the same response, which is, there's no way we get to this point, between now and then something will break and it's a bit of a cop-out answer. But the truth is, it's just really hard to envision a scenario where we're going to have inflation and inflation stay very high, but have inflation stay very high and the outlook for the growth for the economy, being able to support a potential active selling of Treasuries. I mean, that's a very difficult gene to put back into the bottle, right? Like you have to be beyond sure. You have to think that inflation is basically almost out of your control if you want to pull that weapon out of the tool bag. So I'm with you. I doubt it happens.
                                                       I can't rule it out, but in any case it's not going to happen in the near term. It has to say something outside of the base case scenario. You know what I mean? It's one of those things like we've done them exercise, we've done them math, looking at what the likely terminal size of the Fed's balance sheet here is. And it's like, it's going to take so long for them to get there. It's almost an exercise in futility because we're going to have something else, it's too hard to even forecast that at this point, given all the moving parts here. So I guess at this point we can move on to what the impact will be. And I guess I can just start very briefly talking about the impact on credit spreads because it's fairly straightforward. If QE is a spread narrower because it forces people out the credit spectrum then QT is also by definition a spread widener as the inverse of QE.
                                                       I mean, pretty straightforward, but I guess it's worth noting here that relationship has been extremely consistent and observable at all points in time throughout the last decade, when QE really started in 2008. We see anytime the Fed's balance sheet is growing, credit spreads are really narrowing, and anytime that the Fed's balance sheet is shrinking, credit spreads are generally widening. I mean, it's a very good correlation. There's only that window between whatever 2014 and 2017 where the Fed's balance sheet just stayed constant for those years that we see a decoupling of those two data series in the chart because investors were able to refocus on other market variables because the Fed was holding their portfolio steady. But anytime that it was changing, spreads were reacting as we would expect. So from a credit spread perspective, I think balance sheet normalization can only be characterized as a spread widener.
                                                       But I think the point of it is that it plays out over the long term. It's one of those things that will just be somewhat of an upward influence, modest upward influence, particularly beginning, probably not even measurable, but three years from now as we look at that chart between Fed balance sheet size and credit spreads, I imagine the correlation will stay strong. It's going to keep at least modest upward pressure on credit going forward in the very long term. Perhaps the more debatable question is the impact that balance sheet normalization will have on swap spreads.

Dan Belton:                                            Yeah, I think in the long term, it's pretty clear that Fed balance sheet normalization is going to pressure swap spreads narrower. And to see this, I think it's very instructive to look at the last time the Fed was engaged in quantitative tightening, keeping in mind that the Fed was much more measured than they will be this time in 2017 to 2019. But you can really see the impact of quantitative tightening on treasury indigestion through primary dealer positions. So primary dealer positions averaged about a hundred billion in 2017. By 2019, they averaged 235 billion. And that just really represents that as the Fed was allowing these Treasuries to pass through the market, dealers were choking on the supply and that led to Treasuries cheapening relative to swaps. And I think we're going to see a similar thing play out here, if not in a more dramatic fashion.
                                                       So if we saw a similar scenario in primary dealer positions unfold this time, we estimate that SOFR swap spreads in the front end would move about 10 to 15 basis points narrower over the longer on just representative of the fact that Treasuries are likely to cheapen versus SOFR swaps, which typically trade at very tight spreads to Treasuries. Now there's a couple of mitigating factors here. The first being seasonal. Seasonals are typically a swap spread widener in summer months, and June and July are two of the more supportive seasonal months for swap spread.
                                                       So that could be some medium-term widening pressure that we would use as an opportunity to set short positions in swap spread. And then the second one is the Fed standing repo facility, which is likely to keep a lid on repo rates and should mitigate any of the narrowing pressure on swap spreads that we saw and really dominate the market in the third quarter of 2019, but still, as the Fed engages in this really aggressive balance sheet normalization, I think that's going to be a clear swap spread narrower.

Dan Krieter:                                           Well, I add a third mitigating factor and that is the 1.7 trillion dollars still sitting at the Fed's RRP facility. You know, when the Fed removes reserves from the system, it comes from one of two avenues. It'll either come out of RRP or it will come off of banks, parking cash at IOER. And that to me is going to be a very big determinant of, okay, I'll accept it in the long term, it's a swap spread narrower, but timing that might be difficult based off the mix between RRP and IOER. So if the majority of Fed asset rundown comes at the expense of reserves, that banks hold on their balance sheets sitting at IOER, then you get to a potential where you start to see banks being more heavily tipped toward collateral, needing more cash/reserves, and then the potential for selling Treasuries that would be that swap spread narrowing impulse as Treasuries piled up on dealer balance sheets.
                                                       Now you talked about the [inaudible 00:20:19] facility, I'll spend a minute there because what does the [inaudible 00:20:22] facility really mean? Okay. It means that a counterparty will have the ability to finance a Treasury at the top of the Fed's range. So it means that we're not going to have an event like September 2019, but it doesn't mitigate the drift higher in SOFR that will come alongside less reserves in the system. I mean, yes, maybe marginally, it makes a bank more willing to hold collateral whether on the portfolio or in a trading book, because we know we can finance this at the top of the Fed's window.
                                                       So marginally there maybe. But I think that the process for narrowing swap spreads alongside a shrinking balance sheet holds true, at least in the early phases, until we get to a point where we see SOFR starting to bump up against the top of the Fed's range and we're far from that. So the most important determinant for me will be the mix between RRP and IOER in timing when we're going to see the most severe downward pressure on swap spreads. And to that point, how do you see that unfolding?

Dan Belton:                                            Yeah, like you said, the RRP volumes certainly make timing this move more difficult. And we project if the Fed is able to go through with the entirety of its balance sheet normalization, it'll take about 3 trillion dollars out of the system. That's much more than the RRP volumes right now, but it's unclear which will go first, bank reserves or RRP volumes.

Dan Krieter:                                           I mean, mathematically RRP will go to zero if the Fed is able to get the 3 trillion now that they want to. But I do think that at least in the initial phases, RRP volumes are going to be sticky. Like look at who's using that RRP. We know it's money market funds. There's not a strong reason to think that money market fund balances are going to fall quickly. It's not like banks are going to increase their deposit rates to try and track those deposits away from money funds. So they have a hard time seeing corporate treasurers moving their cash balances out of money markets and into bank balances at a big pace going forward. And then also, there's a lot of state and local money that's parked at the RRP now and that state and local money that's stimulus-driven pandemic stimulus programs that has just infused a ton of cash into state and locals.
                                                       And they don't really know what to do with the money, so that money will come out slowly. It will be consumed in one fashion or another, but states and locals are still trying to figure out where that money goes, how they're allowed to spend it under the fiscal stimulus from the Federal government and how that money's going to be sent out. So, you look at state and locals and money market funds, like I don't see a compelling reason to think that RRP is going to fall much. And that's certainly been the experience so far. I mean, we've seen reserves leave the system with Treasury increasing their cash balance significantly since the beginning of the year and RRP hasn't budged. I think it's actually a little higher, if anything.
                                                       So that to me says that it will at least in the early phases becoming off primarily bank balance sheets with IOER, and that could put the downward pressure on swap spreads in 2022 that we're talking about. And perhaps most importantly, I think there's a perception out there that due to the standing repo facility and due to RRP volumes in particular, that balance sheet normalization may not be as significant and narrowing impulse as it was in 2017 to 2019. And I think we disagree with that.

Dan Belton:                                            Yeah, that's right. I think the biggest takeaway for me from this is that for the first time in what feels like a pretty long time, the front end is going to be a pretty important thing to watch as it relates to swap spreads, where it starts to be really monitoring treasury bill supplies, it relates to RRP volumes and things like that. It's been a while since then.

Dan Krieter:                                           Yeah. And naturally, I mean, it's worth noting that we're going to also have to watch the state of the deficit. It's an election year and we all know that things not looking great for Democrats right now. So are they able to get something across, even if it's a water done version, are we able to get at some type of spending bill across between now and November, that potentially increases the path of treasury supply going forward, which would only exacerbate the downward pressure on swap spreads? Will be interesting to watch for sure. But I think that certainly sets us up at least for the May announcement of balance sheet normalization. And that'll certainly be a very exciting meeting to watch for sure. Exciting is one word for it I guess. We'll be back next week everyone. Thanks for listening.

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