Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

Pain and SLR-ow - High Quality Credit Spreads

FICC Podcasts March 10, 2021
FICC Podcasts March 10, 2021

 

Dan Krieter and Dan Belton discuss the recent widening in credit spreads and a change in their view on the near term path for spreads. Finally, they discuss the pending expirations of exemptions for reserves/Treasury holdings in bank SLR calculations, and what the expiration might mean for credit and swap spreads.


Subscribe today on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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.

Podcast Disclaimer

Read more

Dan Krieter:

Hello and welcome to Macro Horizons, High Quality Spreads for the week of March 10th, pain in SLRO. I'm your host Dan Krieter here with Dan Belton, as we discuss the recent widening in credit spreads and a change in our view. Finally, we discuss the looming potential exploration of SLR exemptions for Treasuries and reserves and what it might mean for both credit spreads and swap spreads.

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 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, K-R-I-E-T-E-R@bmo.com. We value and greatly appreciate your input.

Speaker 2:

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

Dan Krieter:

Well, Dan it's been almost a month now since our last podcast. I was out on paternity leave and we had a Macro Monthly episode last week, so in the time since our last podcast, did we miss anything?

Dan Belton:

Yeah, just about a 50 basis point backup in Treasury yields and then a 10 basis point widening in credit spreads. Spreads have been struggling to narrow for a couple weeks, really since the latter half of January before things really started to break, I think in the past week or so.

Dan Krieter:

And it's a shame we don't have a podcast more frequently because we actually changed our view on this last week coinciding with Chairman Powell's speech last Thursday and spreads have obviously moved pretty strongly since then. But ultimately spread's got to within three basis points of our 85 basis point target that our listeners know we've been targeting for a long time now, the all time tights on the index, but it just got to a point for us where the risk to higher spreads just outweighed the potential reward of further spread narrowing is Treasuries continued to march higher and higher. And last week was sort of the final breaking point there when chairman Powell was not quite as dovish as the market expected. Why don't we just talk in detail a bit about the three factors that have precipitated our view to be more bearish on credit spreads here looking forward?

Dan Krieter:

And the first one, I think is just relative value. That was the primary driving force behind our expectation for spreads to hit historical lows. And that relative value has really deteriorated primarily because of higher Treasury yields. And just to put it into numbers very quickly, looking at over the last 10 years. Really the last 10 years is when we've entered into this very low rate regime, credit spreads have averaged a approximately 75 basis point yield enhancement over Treasuries on the broad IG index. And going into late last week, that ratio was as low as about a 60% increase. And just to put that into numbers very quickly, if we look at just the past 10 years, which is really when the economy has entered this very low rate environment, broad index IG spreads have averaged about a 75% yield enhancement over Treasuries, but late last week before this sort of sharp move wider, that ratio is at about 60%.

Dan Krieter:

We were already on the narrow side of the average over the past decade in terms of percentage pickup and we were already very low in terms of absolute spread, but now that relative spread had also deteriorated. And then we had sort of the final nail in the coffin, which was Chairman Powell, basically saying the Fed was not going to stand in the way of Treasury yields continuing to move higher as long as that happened in an orderly way. And so I think with expectations for a strong economic recovery happening here and the potential for inflation or at least inflation fears, Treasury rates may continue to go up and that would likely put upward pressure on spreads at this point, right. Dan?

Dan Belton:

Yeah, exactly. And the way that I've been thinking about it is that higher Treasury yields just raise the bar for further out performance and credit spreads. And this is generally a longer term relationship. When we incorporate 10 year Treasury yields into our model for high grade corporate spreads, we find that for every 100 basis point increase in Treasury yields, we see about 23 basis points or so in credit spread widening. Now this relationship doesn't always hold in the near term. In fact, we looked back at the last nine prolonged instances of Treasury yields moving higher and during those periods, credit spreads actually narrowed during six of them. And the three episodes in which Treasury yields sold off and credit spreads widened, each of these corresponded to an episode where the Fed was cutting off some support to monetary policy accommodation.

Dan Belton:

These were in 2004, 2005, towards the end of the Fed's hiking cycle and then 2013 during the taper tantrum. And then 2019, when the Fed had probably over tightened and took out those three insurance cuts later on. And so we look over this entire period of rising Treasury yields, which really started in earnest back in August. Credit spreads had outperformed for a lot of this move, but we think we've gotten to the point now where higher Treasury yields are a headwind to credit spreads. And we would see any further under performance in Treasury yields as likely precursor to some spread widening.

Dan Krieter:

The second factor driving our change in view has got to be corporate supply, which has really hit the gas pedal in the past say six weeks. Coming off a record February in terms of IG supply for February in any given year, March is off to an extremely hot start and we're starting to see that heavy issuance begin to weigh on the market.

Dan Belton:

Yeah, Dan. We've actually had a record start to this year. We've had 353 billion in gross issuance year to date. That's stronger than any year on record. Thanks to like you said, a record February and then a really hot start to March, which has seen 93 billion in supply through just seven sessions. Although we've hit a little bit of a snag this week in supply, when what had been very constructive new dealer reception and strong primary market demand, has seemingly taken a turn for the worse this week when we saw yesterday and Monday, new issue concessions jumped pretty significantly yesterday. We had a tranche that failed to price and was dropped and just broadly we've seen waning new deal statistics. That's probably due to a lot of things and it's not necessarily indicative of massive spread widening to come, but we're probably going to have to start to see new issues take a breather and some supply slowdown in the coming sessions as the market pauses to take in this new supply.

Dan Krieter:

Yeah. Agree with you there. And it's worth noting that we've seen higher credit quality deals struggle a little more than those further down the credit spectrum. And I think that is just further evidence behind this argument that technicals are really what's weighing on credit spreads here. You think about spreads for higher rated product. There's just less cushion there for them to absorb higher Treasury yields, at least with some of the triple B stuff, you've got a little more cushion in case Treasury yields continue to move up. We've seen that execution hanging in at least a little better or incrementally better than higher credit quality deals. That's just another trend worth monitoring.

Dan Krieter:

And then Dan, I just want to move on quickly to the third factor driving our change in view on credit spreads here and that's really just the outlook on the vaccine virus economic reopening front. And not because we think any of that is less optimistic, we are still firmly in the camp that we're going to see very robust economic environment in the months ahead once these vaccines really get into the general population. Over the course of the next two months, we're expecting a quite strong economic environment during the summer. Only problem there is that that's what's priced and I just don't see how the vaccine economic recovery slash stimulus storyline, I don't see how you surprise to the upside there anymore. We've got 1.9 trillion in stimulus, we've got President Biden saying that he expects there to be enough vaccines for every American adult by the end of May, we've got a strong economic recovery built in. All I see is downside risk from here.

Dan Belton:

Yeah, exactly. And just to build off that point, you talked about how lower graded issues had been out performing higher graded issues. I think that goes to this point as well, where a very strong fundamental picture has been priced in. We've seen that through ratings actions in the investment grade corporate market. For the first time, really since the pandemic, rating upgrades are outpacing downgrades. And so that's why we're seeing out performance by these triple B's. There's less fear of fallen angel risk now, but that's all already priced. And there's now downside risk to that. If there is a worsening in this fundamental picture, that could really start to weigh on spreads as well. It's hard to see positive fundamentals really dragging spreads narrower from this point

Dan Krieter:

And it's worth noting that even in the very robust economic environment that we're expecting in the next couple months, we're probably going to see some cracks. We're probably going to see some businesses that turn out to be not viable that have hung on this far using a combination of monetary stimulus, fiscal support, PPP loans, whatever you want to call it, different types of stimulus to kind of make it through the pandemic and then reopen. And we're going to see stimulus fall off here in this scenario, we're going to see the Fed, maybe not being less supportive, but certainly not more so. And we're going to see there's going to be some businesses that just aren't going to make it and will have to close up shop. And so even in that sort of optimistic scenario that we believe is priced, there's probably going to be a modicum of pain, at least still to come.

Dan Krieter:

Agreed, Dan. I just don't see a lot of upside there. We've only got risk on that front now and given the way everything's moving, just the combination of these three factors was just really too much from a risk standpoint. I wouldn't have a hard time believing if you told me our spreads are going to be 20 basis points wider a month from now. I could see a scenario where that's true. I have a harder time seeing a scenario where spreads are going to be 20 basis points narrower. When that happens, it's definitely time to take our foot off the credit overweight gas pedal.

Dan Krieter:

We're still sort of neutral now and leaning underweight at this point. But I guess to put it in a nutshell, we are going to see probably some pockets of out performance. We're going to see days where unemployment reports come in really high like we had last week or the equity market's up or good news on the vaccine front. There's a lot more being rolled out every day. And we're going to see some pockets of spread narrowing here. I think the main change in our view would be that we should view those pockets as opportunities to sell into strength more than what should be expected here. Because I think in the next couple of months, spreads might start to move a little bit wider.

Dan Krieter:

And that brings us to the next topic we're going to talk about here today. And that is touching on the SLR storyline that's made a lot of headlines recently. Just to sort of set up how this matters for credit spreads. Our listeners will know we've made sort of a big deal at about the potential for crowding out. We talked about heavy corporate supplies, one of the main factors for why we were changing our view on credit spreads in the last segment. And we didn't mention crowding out, which is something that we're definitely monitoring given how much Treasury supply is supposed to come. Again, 1.7 trillion after Fed purchases and coupon supply this year. Easily a record and in a market environment where rates are going up and there's potentially some difficulty in finding a home for 1.7 trillion in Treasuries. As inflation fears and rates go up, you do run the risk of crowding out private market borrowers and that's particularly acute given how heavy corporate supply has been.

Dan Krieter:

How does that bring us to the SLR? Well, there's the potential for the SLR becoming an effective increase in Treasury supply and we'll get to how that happens. But I guess first from a high level, for anyone that may not be familiar, Dan, why don't you give us just the sort of quick overview of what's going on with the SLR in the next 20 days and what it could mean?

Dan Belton:

Yeah, so back in April, the Fed exempted Treasuries and reserve deposits from banks' supplementary leverage ratios and these ratios apply to the G-SIBs as well as category three banks, which are generally banks with 250 billion in total assets or more. And this exemption of Federal Reserve deposits and Treasuries is scheduled to expire at the end of March, but there's a lot of uncertainty over whether or not that will be extended. And there's reason to expect that it would be extended given this looming supply you just talked about, in addition to likely increase in reserves from the Treasury running down its cash balances. In 2020, banks picked up a significant portion of Treasury net issuance because of this SLR exemption. Now, if this exemption were allowed to expire, there's reason to think that banks would have to unload some of the Treasuries they picked up over the past year, which would probably exacerbate some of the moves that we'd see in the market regardless.

Dan Krieter:

Why don't we start there, Dan? Why don't we start with just trying to value the size of the potential flow coming off the back of the SLR? And then we can talk about market ramifications and things like that afterward. You alluded to the fact that even just looking at Federal Reserve Z1 data, banks have picked up upwards of $300 billion in Treasuries in the past year, which is what? Nearly a 50% move higher. They've also added about a trillion dollars in reserves that sit on the bank balance sheet. Banks have grown significantly in the last year and if this SLR exemption goes away, there's the potential that reserve slash Treasury holdings are going to have to be reduced significantly. The question is how much? To answer that question, we looked at the SLRs of all the G-SIB and category three banks that we could get data for as of most recent data, which is Q4 2020.

Dan Krieter:

And we looked at their SLRs both including and excluding the exemption for Treasuries and reserves. And what we found was that in general, G-SIB SLR scores were about a 100 basis points higher, including the exemption and that excluding the exemption, which might happen at the end of this month, we'd get SLR scores as low as 5.8% or so. Now it's important to note here that the minimum SLR that has to be maintained is 5% and the lowest we said for a G-SIB was 5.8%. Still 80 basis points above that level. There is also uncertainty over whether or not banks would even have to take action or if they would just run lower SLRs. But what we did was we went and looked at then the SLR they ran at the end of 2019 to try and get a sense of, okay, let's consider that a quote unquote natural rate of SLR for a bank.

Dan Krieter:

That's the SLR that they would like to maintain. All banks want to have a minimum buffer above the 5% for a couple reasons, just uncertainty over how some calculations go for huge banks into quarter end. Also for analytical purposes, nobody wants to see a bank getting close to those minimums so they all want to be above. And we looked at their 2019 SLR as their quote unquote natural SLR level that they would like to be at. And then what we did was we looked at the SLR excluding exemptions. Let's say 5.8%, that was the number we were using before. And then let's say that the bank's 2019 SLR was 6.3%. We made the argument that the bank would want to get back to their natural level of SLR from 5.8 to 6.3 and they would do that by reducing reserve and Treasury holdings.

Dan Krieter:

We did this for all the G-SIB banks and we came up with an aggregate need to reduce reserves and Treasury holdings by the G-SIB of banks of just over 600 billion. And then we had to try and answer what would be the mix between reserves and Treasuries? To answer that question, we went and looked at how much each individual G-SIB bank has increased reserves and Treasuries in the past year. Again, the theory here being that a bank has some optimal mix of reserves and Treasuries as they deal with their myriad of regulations they have to abide by. LCR, SLR, daylight overdraft, living will stuff. There's just some natural mix of reserves and Treasuries. And what we did was we just assumed that for each individual bank, which is on aggregate over $600 billion need to reduce reserves, we said that each individual bank would reduce reserves and Treasuries according to the same ratio that they increased those two things in the past year.

Dan Krieter:

Basically holding the mix of reserves and Treasuries constant for the banks that would theoretically want to increase their SLRs once the exemption went away. And a lot of numbers here, but just cutting to the chase here with the bottom line, we found that if banks ultimately increase their SLRs back to where they were at the end of 2019, we saw the potential for reductions to reserves of about 400 billion and a potential reduction in Treasury holdings of about 200 billion. But Dan, the risk to that might even be to the upside in Treasuries because reducing reserves is easier said than done. You have to sort of get rid of deposits, that's the only way to get rid of reserve. If reserves are more sticky, banks may actually have to sell more than that 200 billion in Treasuries.

Dan Krieter:

Now here, I want to stress, this is our estimate of what the potential flow could be in one scenario from the SLR, where banks wanting to get back to the 2019 level. But there is an extremely high amount of uncertainty here surrounding the SLR. And Dan, why don't you walk us through some of the dimensions of that uncertainty and why we can't just say a bank's going to sell 200 billion in Treasuries. In fact, they might even not even sell any or they could sell more than that. Where is all this uncertainty coming from?

Dan Belton:

Yeah, so there's a lot of sources of uncertainty. First of all, most obviously the SLR exemption could be extended and that extension could take many forms. But in our base case, we see that exemption being extended three to six months, which would gives banks at least a longer runway to manage their reserves and Treasuries to where they need to be in the future. Second, like you mentioned, the G-SIBs currently have SLR ratios that are compliant, even if you include Treasuries and reserves, which are currently exempted, so they don't necessarily need to do anything to become compliant right now. Yes, they would probably prefer to see higher SLRs similar to the ratios they had before this exemption, but they don't necessarily need to do anything to become compliant right now. And so that gives banks more time to manage these ratios.

Dan Belton:

Third, banks could raise more capital. That's possible too and that would negate any need to manage down their reserves and Treasuries. And fourth, let's assume that banks do need to manage higher their SLRs. They could always manage down reserves. Now the stock of reserves in the banking system is more or less fixed by Fed policy, but that doesn't mean that the current share by G-SIBs and category three banks needs to sit with those same banks. Reserves could be spread more evenly across the banking system, which would negate the amount of Treasuries needing to be sold.

Dan Krieter:

Yeah, I think you do a great job laying out the uncertainty there. I do think that if we do ultimately get to that fourth layer there, so first that the SLR is not extended, banks do decide to take action to get their SLRs higher and they don't hold more capital. Getting rid of reserves is pretty difficult and we're already had 400 billion in reserve reduction in our base case. There is significant potential for selling of Treasuries I think if we get to that fourth layer of uncertainty, but that's still a lot of layers to get to before we get to that $200 billion flow. It's certainly a potential scenario, but there's a lot of certainty around it as I think we just demonstrated.

Dan Krieter:

What does SLR ultimately mean for credit spreads and then for swap spreads? Let's start with credit spreads. Well, if the exploration of Treasury and reserve exemptions for the SLR is ultimately just an effective increase in Treasury supply, then the impact on credit spreads would be likely the impact we'd expect from an actual increase in Treasury supply, which you laid out earlier. Near term, that's a spread narrower probably, but then in the longer term, it can actually be a spread widener as we deal with some of that crowding out impact that we touched on earlier.

Dan Krieter:

And at the point where we are now, where rates are going higher, spreads have already turned. I'd actually be more worried about credit spreads in a scenario where banks were suddenly selling significant sizes of Treasuries. At least in the corporate sector, maybe some of that high end agency SSA paper, that's more government like, maybe that would benefit from something like this, but corporate paper where there's a ton of supply outstanding. I think you then that would be more worrisome for spreads. And then talking about swap spreads. Obviously the market has interpreted the end of the SLR as a strong narrower for swap spreads. And there's certainly a very strong argument to be made for that. But I think the near term outlook for swap spreads is a little more ambiguous than perhaps the market has been pricing in. You take in conjunction the end of SLR exemptions, but also the pay down in Treasuries account at the Fed, which is an influx in reserves.

Dan Krieter:

And I'm not actually certain that on balance, that's going to result in narrowing influence on swap spreads. Just in the past what? Month and a half, we've seen Treasury's cash balance run down about 300 billion. And in that time we've seen inflows into money funds pick up. We've seen SOFR trading at the very, very low end. Obviously there's a lot of things going on there, GFC cash, what have you, but it's not a coincidence that Treasury's cash balance has run down 300 billion and SOFR is at the very low end of the range. And we're only down 300 billion. We could be done another four to 500 billion in just a matter of weeks from here as stimulus payments start to come out and Yellen runs down that cash balance. And so we could get an even larger flow of putting downward pressure on repo rates.

Dan Krieter:

And if we estimated 200 billion in Treasury supplies coming from banks at the end of SLR, let's even double that. Let's say we're wrong by half and it's 400 billion in Treasury sales. Well then that's enough to merely offset the reserve creation coming from Treasury's cash balance being run down at the Fed. I certainly think there is a scenario where the end of the SLR is extremely negative for swap spreads and you get a strong narrowing. I just think we might have already priced in a lot of that. And you look at the uncertainty, you talked about Dan, among all those dimensions there first, will it be extended? Even if it's not, are banks going to suddenly start liquidating hundreds of billions of Treasuries? I think they'll sell some Treasuries, but they're not going to immediately have to increase their SLRs all the way back to where they were at the end of 2019.

Dan Krieter:

They can say, "We had this ratio exemption over time. We're going to build it back up." It's not going to be a sudden $200 billion flow that hits the market. It's going to be probably over the span of quarters that those SLRs increase. They could also hold some capital, which they'll probably do at least some of that on the margin and reduce reserves. There's just a ton of uncertainty there. And even in the worst case scenario where they just were to suddenly sell a lot of Treasuries in a very short amount of time, we have this big influx of reserves coming from the pay down of the Treasury's TJ account. That's probably enough to at least offset and probably be actually larger than the flow of Treasury sales coming from the SLR exemption.

Dan Krieter:

Given the narrowing we've seen in swap spreads already down to eight basis points in five year spreads right now, I still think long term, we're probably going to see continued downward pressure on swap spreads, but in the very short term, I think this SLR move in swap spreads might be a bit overdone and I could actually see some value in some tactical long positions in belly swap spreads at the moment. Do you have anything to add there?

Dan Belton:

Yeah, I think there's a lot of uncertainty like you mentioned, with regard to these cross currents between the future of SLR and Treasury's cash balance. My preference would be if not to initiate a tactical widener, to maybe just wait for more clarity on the SLR and what happens with Treasury's cash balance. But they're sure to bring some more volatility in the near term.

Dan Krieter:

Cardar, you're thinking of that. Okay, Dan. Obviously we've covered a lot in today's episode, but there's a lot going on right now. Anything else you want to talk about today or come back next week and see where we are?

Dan Belton:

Think that probably covers it for today. 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 FIC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated and BMO Capital Markets Corporation. Together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally and not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment for strategy referenced herein may be suitable for you. It does not take into account the particular investment objectives, financial conditions or needs of individual clients.

Speaker 2:

Nothing in this podcast constitutes investment, legal, accounting or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you or in your best interest in you to the extent applicable, go rely solely on advice from your qualified, independent representative making hedging or trading decisions.

Speaker 2:

This podcast is not to be relied upon in substitution for the exercise of independent judgment. You should conduct your own independent analysis of the matters referred to herein, together with your qualified independent representative, if applicable. BMO assumes no responsibility for verification of the information in this podcast. No representation or warranty is made as to the accuracy or completeness of such information and BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter and information may be available to BMO and or its affiliates that is not reflected herein. BMO and its affiliates may have positions long or short and affects transactions or make markets in securities mentioned herein or provide advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

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



You might also be interested in