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Pondering the Peak - High Quality Credit Spreads

FICC Podcasts Podcasts October 19, 2022
FICC Podcasts Podcasts October 19, 2022

 

Dan Krieter and Dan Belton discuss their outlook for credit spreads into year-end and their expectations for the cycle peak in spreads. Topics include possible remedies to credit market illiquidity and the implications of a strong consumer on the likely path of Fed policy.


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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 Horizon's High Quality Spreads for the week of October 19th, Pondering the Peak. I'm your host Dan Krieter here with Dan Belton as we discuss moves and credit spreads over the past few weeks and provide estimates for what we think the peak and spreads will be in the current cycle and reasonable estimates for when that might occur.

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

Well, Dan, it's been a few weeks since our last podcast. We had some business travel and a monthly edition of the full team podcast. And looking down at spreads here, we're at 164 basis points on the broad IG index as measured by the Bloomberg Index. And when we last recorded it was 163 basis points. So, from that measure we are roughly unchanged, but obviously that masks a ton of volatility we've had in the time between. So, why don't you get us caught up on what's been happening in credit in the past couple weeks?

Dan Belton:

 

Yeah. It's really been all about volatility. Credit spreads have seen really two peaks now in the last month or so. We peaked at the end of September and then snapped narrower and then started to retrace that out performance reaching another peak just a few sessions ago. And so now credit spreads have seen five distinct peaks in 2022 with each one being higher than the one before it. And each one has been followed by a snap narrower in spread, some rebound outperformance. And to me that's really indicative of one of the underlying themes of this year, which has been elevated volatility, which has really reduced the liquidity in credit spreads. So, what we've seen is periods of illiquidity with a bout of optimism immediately following it, but that optimism tends to be short-lived as inevitably a more hawkish Fed comes to be priced and credit spreads continue their longer term drift wider, and that's exactly what we've seen over the course of October.

Dan Krieter:

 

Yeah, that's certainly been the theme for all of 2022. Market participants continue to try to price in the peak in spreads, and I think there's some aspect of FOMO there where every time we see a peak in spreads, investors certainly conditioned over the past 10, 12 years to buy the dip and that has certainly not proved a profitable strategy thus far this year. Buying the dip has continued to prove premature as inflation remains stubbornly high and expectations for where terminal is and where the Fed's pivot is continue to be pushed out. We've entered this pattern now where I think we have 75, 50, 25 priced into the next three Fed meetings and then we just keep continually pushing that out. Every time we get another hot CPI read like we did last week, we price in 75 to the next meeting, 50 to the meeting after that and 25 to the meeting after that.

The market's understanding of what the Fed's preferred path is clearly 75, 50, 25 and then pause. We just keep pushing that timing out with each incremental month of hot inflation. So, that's basically where we are right now. 75 is fully priced in for November. We're between 50 and 75 for December. And once again, when we're talking about credit spreads here, that has to be the most important consideration. Are we reaching the point where the Fed is going to finally pivot? So, I think the focus of our episode today, Dan, should be the view on credit both in the near term and in the longer term, maybe trying to set up some long range targets here. So, I guess I'll ask you this. In the near term, spreads are within one or two basis points of year-to-date highs now. Are we going to get another bounce like we've seen in the previous four peaks or do spreads need to keep going wider still?

Dan Belton:

 

Yeah. With this illiquidity that we've been seeing in the market, it's really hard to determine the immediate term path of credit spreads. And I think that's why in most of our conversations with investors and even issuers, there's a preference right now to sit on our hands and wait and see the immediate term path of credit spreads. So, I think into year end, I'm maintaining my expectation for about 190 basis points for credit spreads into the end of the year. So, I'm expecting them to drift wider over the next two and a half months or so. Now, in a week will they be narrower or wider? It's really hard to say just given how much illiquidity there is, given how primary markets have been very volatile in the volume of supply and also the reception to that supply. But into year end, the two factors that I'm most looking for are increased hawkishness from the Fed and then liquidity.

Will this liquidity issue be resolved into year end or will it only get worse as volatility remains elevated? So, I'm expecting more hawkishness to be priced into the Fed's path of policy into year end. As you mentioned, we keep pricing it another 75 as each hot inflation report comes in. We had comments this morning from Neel Kashkari saying basically the Fed can't pause until there is some evidence of a slowdown in inflation. We haven't gotten that yet, and I think the current terminal pricing of 495 or so in the Fed funds rate is going to prove too low.

I wouldn't be surprised to see a terminal policy rate of closer to five and a half percent. As that becomes priced, credit spreads are likely to continue to drift wider. But to your point, there is going to be some by the dip mentality that emerges at various points into year end. We had all-in corporate bond yields top 6% earlier this week for the first time since the financial crisis. Undoubtedly that's attractive for certain investors, like long-term investors. You can see some real value there from an all-in yield perspective. So, I'm expecting this volatility to remain but into year end spreads it should drift wider.

Dan Krieter:

 

Yeah. And you're seeing some headlines also about some crossover buying from high yield and into IG just given how high all-in yields are. So, yeah, for sure it'll be volatile and it'll be a choppy path. But I'm with you that we need to see some more widening. And you talked about hawkishness and how the Fed will not likely pivot until there's some signs that inflation is meaningfully slowing, and there just isn't. I mean, obviously we've had core month over month CPI at 0.6% two months in a row now. But even looking more deeply at the underlying consumer data where we just got some updated figures from Q3 bank earnings, there's just no evidence that the consumer is weakening meaningfully enough to have the Fed potentially pause and see how the restriction they've put in now ultimately affects the consumer. I mean, for me, one of the main themes coming into this year was the elevated stock of savings that consumers had maintained coming into 2022 after stimulus payments and the extraordinary environment of the pandemic.

And there was this thought, and I agreed with it, that stimulus payments had propped up those savings and that through the first half of the year we should see those savings start to come down and would ultimately be exhausted, which would naturally cool inflation and likely lead into recession. We haven't seen that. Household savings remain elevated and that's somewhat difficult to square with real wage growth that we've seen for most of 2022. But I think the key point here is that, in aggregate, real wage growth has been less. But when you look at the two bottom income quartiles, they really haven't yet been impacted by Fed tightening to the extent that the upper quartiles have. And we know that upper quartiles have the ability to withstand high inflation better than the bottom quartiles. And as rationale for that point, we looked at the wage growth by income quartile available in the BLS data series.

And if you look at the bottom two quartiles of income, that wage growth has actually kept pace with inflation and is actually above inflation in certain areas. High income quartiles, their wage growth hasn't been as significant. So, you see, in aggregate, negative real wage growth, but for the bottom two quartiles, their wage growth and the strong employment market has kept pace with inflation. So, when viewed in that sense, excess savings, particularly among the lower quartiles of income, isn't as surprising as we might expect beforehand. And you look at things like the wealth effect. Well, most Americans don't own stocks. They don't own long-term investments, particularly in non-retirement accounts. So, you're not going to see a strong wealth effect there. The housing sector is likely a much larger wealth effect on bottom quartile earners. And while we have seen housing prices start to come down, the depreciation in housing prices has not yet been significant enough where we might expect a more meaningful wealth effect for those consumers.

And we know the employment picture remains very strong. So, taken as a whole, and this is enhanced by what we saw some of the bank CEOs talk about in their earnings calls, the consumer is still very strong. Debt delinquency is very low. Savings is still high. And so in aggregate, the entire picture just paints one of inflation is likely to stay elevated here for a little bit longer and the Fed is likely going to have to be more hawkish than the market is even implying now. So, I think your call of 5.5% on terminal is probably the right one and the risk may lie to the upside.

Dan Belton:

 

Yeah. It's amazing when you think about the fact that the Fed really pivoted last November and started to increase the pace of tapering of its asset purchases. Really, that was when they started their hawkish path and they've been able to do nothing to the path of inflation. It's really remarkable. And like you said, I think a lot of it goes to the strength of the labor market, particularly in that lower income segment. There's just been a clear shortage of workers and excess demand for labor and that's why we're seeing a continued strength in the consumer that I think nobody really saw coming.

Dan Krieter:

 

And then the other factor that you alluded to earlier, poor liquidity is the other main driver of our expectations for spreads that continue going wider. And poor liquidity's obviously been a central theme for 2022, and we've all seen the US Treasury liquidity indices, the Bloomberg one probably the most famous, with liquidity now at some of the worst levels ever recorded outside of the peaks of the 2008 and 2020 recessions. And for credit specifically, there are a few different ways to observe the impact of poor liquidity. We've talked in previous episodes about the divergence between the Fed's new corporate market distress indices and investment grade and high yield and how we've seen that dislocation likely being attributed to poor liquidity. Another one that really we need to talk about here is the divergence between credit spreads and credit derivatives, IGCDX here in the past four to six weeks, which it's been a theme for a lot of the year, but it's really intensified in the past couple weeks, it feels like.

Dan Belton:

 

Yeah, Dan. The daily and even weekly performance of cash index spreads in CDX has broken down significantly over the course of this year. And if you look at spreads this month, credit spreads at the index level are anywhere from two to five basis points wider month to date as we sit here recording this. CDX is 14 basis points narrower over that period. So, what we've been seeing is there's a strong risk on that we're seeing in the stock market that we're seeing in credit derivatives that cash index spreads are just not participating in. That's reflective of this poor liquidity. I think it goes back to a few things, but the primary driver of it, I'm seeing, is volatility. And we've seen volatility impact the market in a lot of different ways. There's been, as I alluded to earlier, there's been very little supply. The supply that has come has come with elevated concessions.

And what we see as a consequence of these elevated primary market concessions is there's increased risk for investors buying in secondary. Are you going to buy in secondary and potentially have more deals come in the same sector from the same name the next day and re-price that whole curve wider? So, there's a strong incentive to just sit on hands and that makes the liquidity problems worse, as nobody's really willing to stick their neck out there and buy credit in the current environment given this volatility, given this lack of liquidity. And I think that's why spreads are so complacent and not participating in this rally that we've seen in other asset classes.

Dan Krieter:

 

Volatility is certainly a key component of the illiquidity we've seen, but there's also certainly structural components to the illiquidity that we have to talk about as well that imply that liquidity is probably not going to get better in the very near term. And those are, I mean, we've talked about Central Bank intervention. I don't think we have to say anything more about it. Central Bank intervention likely to be a theme in the months ahead as the dollar remains extremely, extremely strong with ramifications for liquidity, we all know, looking back to 2015 and 2016., but also looking at bank balance sheets in particular, you're hearing more and more about RWA capacity limits. Certainly the banks are already leverage constrained. We still haven't had any type of adjustment to SLR. But even looking past SLR, J.P. Morgan said in their most recent Q3 earnings that they anticipate in coming months and quarters for their RWA constraints to become the binding constraint and it will no longer be SLR, which it has been traditionally.

So, there's risk-weighted asset problems. It's a function of strong loan demand for the past several quarters. It's also a function of securities portfolios that are massively underwater held by a lot of the big banks that, as the Fed increased monetary supply after 2020 and loan demand was soft, they blew up these investment securities portfolios that are now trading at a much lower dollar price. And to capture that, let's just look at the percentage of securities held by banks and AFS and held to maturity portfolios. A year ago between 20 and 25% of bank security holdings were designated as held to maturity. Today that figure is between 40 and 45%. We basically doubled as banks tuck away securities holdings into HTM so they can avoid the flow through to earnings of AFS unrealized losses.

So, that's a ton of bank balance sheet capacity that's just locked away now in HTM portfolios and I have to think that has a significant impact on liquidity and that's only going to continue to get worse alongside quantitative tightening, which we've talked about a lot in previous episodes, that is really only now starting to really sink its teeth in. So, it's difficult for me to see liquidity improving meaningfully going forward. I think year end and the way year end goes this year will be interesting for the first time in many years. We'll see how year end mechanics go with banks clamping down on balance sheets, but there are a few solutions potentially on the horizon. We've talked about SLR for a while now. The new one of course that's being talked about a ton in the market now is the potential for Treasury buybacks. Dan, how are you viewing this potential solutions and will they be the silver bullet to liquidity that the market is looking for?

Dan Belton:

 

No, I don't think so. With credit specifically, I don't see any meaningful relief to the illiquidity coming from Treasury buybacks. I think it could possibly help with some off the run securities in a very micro fashion, but I'm not anticipating that's going to change the liquidity picture for corporates or any of the other asset classes that are under pressure right now.

Dan Krieter:

 

Yeah. I mean, that's more attacking the symptom than the actual problem, right? I mean, big spreads between on the run and off the run Treasury securities is a symptom of illiquidity. It's not the driver of illiquidity. So, yes, the Fed will buy off the runs and buy them with bills, and so maybe with some bills you can finally start to chase some money to the RRP which could potentially have some benefit for liquidity, but probably not much. It's not going to be something that's going to suddenly cure the illiquidity. I agree with you. What about SLR?

Dan Belton:

 

Yeah, SLR should help. It should be more helpful, I think, than the other solution that's been floated. I think clearing up bank balance sheets is going to go a long way towards relieving some of these liquidity constraints, but I really think that the primary one is going to be clarity on the path of the Fed's hiking cycle. I think once we have more convincing evidence that the Fed can go off of this 75 basis point cadence, once we see inflation start to move lower for a couple consecutive prints or even three consecutive prints and then we have a path to a Fed pause, that's when I think that some of this liquidity is going to get better.

I'm looking for that to happen maybe early next year. Then of course it's going to become more challenge from quantitative tightening, which I don't think is a near term thing. I don't think quantitative tightening is going to lead to significant liquidity concerns on its own in the near term. As we get into 2023 and the Fed's balance sheet starts to become more and more unwound, that's a different story. I'm looking for liquidity to then turn a little bit worse in the second half of next year, but I could see some relief in the early part of 2023 if we get some more clarity on the Fed.

Dan Krieter:

 

Yeah. Just quick note on the SLR. We've talked about it before. Banks are already sort of positioned for an exemption in the SLR, and so when it actually comes I don't think it's going to result in a huge improvement in liquidity. It's going to come from what you said, clarity on the path of the Fed. And as we talked about earlier this episode, we don't think that's coming here in the next couple months. So, suffice it to say, Dan, that we remain bearish on credit spreads in the very near term, and I think at this point it's time to start pondering what would be a fair target for the peaking credit spreads. And you just talked about potentially Q1 is a reasonable target for when the Fed might be able to actually pause or pivot, if you will. So, let's talk about that for a little bit. When asked the question, where do you think credit spreads are going to peak in the current cycle, how are you analyzing that question?

Dan Belton:

 

So, if you look back at recent peaks, we've seen three recessions since credit spreads have been published on a daily basis. We had obviously the early 2000s, the great financial crisis, and then COVID in 2020. And because of the strength of the consumer and corporations that we've talked about earlier in this episode, I'm throwing out the peaks of 2008 and 2020, looking at the early 2000s recession as the most likely guide for what this recession might look like. And I think there's two important things to take away from that recession. First, the peak and credit spreads there was not nearly as high as it was in the two more recent recessions. We saw credit spreads peak at 257 basis points in the early 2000s, and I think that's probably a reasonable gauge for where we might see spreads peak. I would probably take lower than that. I'm looking for more like 225, which is actually in line with a couple more recent non-recessionary periods since the financial crisis in early 2016 and then 2012.And I'm looking for a peak lower than in 2002 because I think the corporate sector is much stronger than it was then. However, there's one factor that should give pause to anyone looking for the low 200 basis point range as an opportunity to get in and expect significant narrowing in credit spreads, which is that spreads were elevated for a much longer period of time in that episode. And the reason for that is that the Fed response was much less dramatic than it was in response to financial crisis when we had policy rates moved to zero and quantitative easing. And then in 2020, of course, policy rates moved to zero very quickly and quantitative easing at an unprecedented scale combined with fiscal policy response. I don't think we're going to get nearly the same amount of policy support this time around, if we get any at all. So, for that reason I'm expecting credit spreads to remain in the 175+ basis point range for a prolonged period of time next year.

Dan Krieter:

 

Yeah, just to put a little more nuance on that point, the extraordinary Fed and fiscal response to both the last couple recessions really short-circuits the downgrade default cycle that typically coincides with recession in the corporate market. So, when you look at the path of downgrades, Moody's has the data on this annually since 1981, when you look at the upgrade downgrade ratio in both 2008 and in 2020, we saw only two years where downgrades outpaced upgrades. If you look back to the '01 environment, it was five consecutive years when downgrades were more than upgrades, and in four of those five years it was downgrades to upgrades at more than two to one. So, that's the type of sustained downgrade default cycle where you don't have the Fed riding to the rescue that we could see this time around. Now, in '01 I think there were a few aggregating factors.

Obviously corporations were very overvalued. We had accounting scandals in 2002. That likely meant downgrades were more severe than they will be this time. But I think the cycle in the current environment will be longer than we saw in either '08 or 2020. So, I'm with you on the peak and spreads in the 225 basis point range in terms of absolute peak. But I think spreads are going to trade at what we would consider quote-unquote, "elevated," which generally more than 150 basis points, which is the long term average for credit spreads. I think we're going to be trading at, quote-unquote, "elevated" levels for much longer than we've gotten used to in the recent experience. Anything else before we go, Dan?

Dan Belton:

 

No, let's wrap up there. Thanks for listening.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at Daniel. Belton, 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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