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Timing is Everything - High Quality Credit Spreads

FICC Podcasts January 12, 2022
FICC Podcasts January 12, 2022

 

Dan Krieter and Dan Belton discuss their outlook for credit spreads in the medium-term including the major headwinds and tailwinds facing the market in 2022. Topics include inflation, quantitative tightening, and how to position given a near-term constructive tone against a backdrop of significant risks later on in the year.



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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 January 12th. Timing is everything. I'm your host Dan Krieter here with Dan Belton, in our first episode of 2022, where we lay out our expectations for credit spreads in the next three to six months.

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. 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 of the participants and not those of BMO capital markets, its affiliates or subsidiary.

Dan Krieter:
Well on behalf of both Dan Belton and I, I'd like to start by wishing everybody a very happy new year. This is our first High Quality Spreads episode of the year after a monthly episode with the whole team last week. And really it's our first podcast in a month basically since the December FOMC after a little holiday break. A lot has changed over the course of the past month, Dan. We've gone from questioning whether or not the Fed is going to accelerate the pace of asset purchase reductions to now talking about a shrinking Fed balance sheet, all in the span of one month. We've obviously seen Treasury rates moving significantly, with the 10 year over 30 basis points higher since December FOMC. And I guess just to start out, Dan, how have credit spreads responded during the past month?

Dan Belton:
Yeah, so credit spreads have actually hung in pretty well despite all this volatility. You talked about the acceleration of the perceived timeline of Fed action. You didn't mention that the March rate hike has become increasingly priced too, now about 86%. But over this time, credit spreads have actually moved slightly narrower granted most of the move narrower was done at the end of 2021 on fairly light trading volumes. But even as we've had some wobbles in equity markets, as well as rising treasury yields, credit spreads have been pretty resilient sitting at 94 basis points in the Bloomberg Barclays index versus at our last episode on the FOMC date, about 98 basis points, so a little bit narrower on the broad index.

Dan Krieter:
Yeah, you said it. I mean narrower, but like you said, most of it in 2021. I think looking at this morning since the start of the year spreads have traded in just a three basis point range. We've traded within one basis point either side of that 94 basis point level you talked about earlier, so we are seeing remarkable stability amidst volatility in other markets here in credit spreads. And so we'll use that as a launching off point here to talk about it being appropriate in our first episode of the year to just lay out our view, our expectations for what we're going to see from the spread markets here in the first, say three to six months and hit on just sort of the high level of factors behind each.

Dan Krieter:
And from a high level for me, I think what we're seeing here with the stability and credit spreads at the beginning of the year is just what you call cross currents. We do see tailwinds here for credit in the near-term that should be putting downward pressure on credit spreads. But at the same time, obviously, there are significant headwinds as well. And I think in an environment like that, you see technicals a very important role in the near-term path of credit while fundamentals in the macro picture sort of lead this neutral view. And obviously technicals is extremely important at this time of the year.

Dan Krieter:
Anyways, I'm sure we'll talk about that a bit more later in the podcast, but for now, let's just start by talking about some of these cross currents here for credit markets. And let's talk about the tailwinds first. And I think if we're going to talk about tailwinds, we have to start with COVID 19, the Omicron variant. I know that doesn't sound like a tailwind, but if you really think about what it means for credit, there's a pretty strong argument that it is actually somewhat of a tailwind.

Dan Belton:
Yeah, I agree. I think counterintuitively, it can be viewed as something of a tailwind. And I think that mostly stems from the expectation that we're not going to see a renewal of widespread lockdowns in the United States. We are in a sense learning to live with this variant. All available evidence shows that the variant is not as deadly as some of the other strains of the virus, but it still can grant immunity for those with Omicron. So from a high level it doesn't seem like this is going to significantly weigh on economic growth or corporate profitability. It might reduce it somewhat, but it's not going to be something that causes broad financial market stress. And so from that perspective, it could be viewed as a positive.

Dan Krieter:
Yeah, I'm with you. We won't talk about COVID this entire podcast here, but I think you said it, there won't be a significant impact to consumption. Obviously we've seen consumption extremely high, highest print in the existence of the data series in 2022 on the consumption side. And we should not think that the Omicron variant is going to impact that strong consumption that we've observed in the past couple quarters. And more long term there's a strong argument to be made that Omicron could actually work to reduce the long term risk of COVID as it becomes more endemic and people just learn to live with it. So I think we've talked about COVID as long as we need to here, looked at it as a tailwind, particularly because consumption should remain strong. And so should the outlook for corporate earnings at least in the very near-term.

Dan Krieter:
And then the other tailwind I want to talk about for credit is the fact quantitative tightening I think isn't on the table yet. It is crazy how far the conversation has come in just one month. But the fact that sitting here right now after the release of the minutes of the FOMC December meeting last week, finding out the quantitative tightening, isn't likely in the first half of 2022. I think that has to be considered a good thing. You'd mentioned that we're seeing rate hikes being pulled forward and that assuming that great news for credit, but I think you and I both agree that quantitative tightening or the size of the Feds balance sheet is a lot more important than rate hikes or at least the first couple rate hikes of 2022.

Dan Belton:
Right and to that point chair Powell was on the tape yesterday for his confirmation hearing. And he affirmed as much, saying that while quantitative tightening is a 2022 story most likely, he did seem to indicate that it's not going to come at least at the same time as the first rate hike which was an outside possibility before the release of the Fed minutes for the December meeting. And so this is going to play a major role for risk assets, I think later on in this year, but it's going to be more of a technical headwind for credit as opposed to one that's going to weigh on spreads preemptively. So I think this is going to be mostly a second half story. I don't think that spreads are going to price to quantitative tightening well before it actually starts to mechanically work its way through the market. And that seems like a second half story.

Dan Belton:
Our base case right now I think is probably that quantitative tightening starts after the second rate hike of the year which is probably right now slated for the June meeting. So chair Paul has indicated that quantitative tightening is going to come earlier than in the last cycle and probably more quickly. So a second half of 2022 start would be an earlier start than in 2017. And then with respect to the pace, that's going to be really important, but probably more to come on that in the next couple Fed meetings. One thing that is worth noting is that Lori Logan, the head of the New York Fed markets group was out earlier this week saying that the way that quantitative tightening was conducted last time using the caps that gradually increased every quarter was an effective way to do it. So we're looking for potentially the same structure with respect to quantitative tightening, maybe just a quicker increase to a higher level of caps this time around.

Dan Krieter:
Yeah, so from a high level, I think a really good information there, but I think boiling it down to the second half of your story, I generally agree with that. I could maybe take small issue with the idea that spreads wouldn't price it in. I think they would maybe a little bit. It is mostly technical I agree with that, but I think obviously its quantitative tightening comes more into focus I think that would certainly be a negative for credit spreads. Just to clarify something I said earlier, I'm not saying that rate hikes can't widen credit spreads, but I think coming into the year we knew that rate hikes were coming and there was already expectations for a significant liftoff campaign. Sure it's been pulled forward a little bit, but moving from March to June, how big of an impact that's really going to have is probably not much on credit spreads in the near-term.

Dan Krieter:
It's going to be the next step. Are we going to suddenly start pricing in 50 basis point incremental hikes? Are we going to start talking about quantitative tightening in the first half of the year? These are the big things that could go for credit, and I just don't see that in the first half of the year. Because I think if we look at the tone of the Fed in the last couple meetings, I think the Fed still expects inflation to moderate on its own at least to a certain extent. They no longer have the luxury of waiting to find out if that's true. They have to start taking steps towards cooling this economy particularly with inflation, we saw the print this morning, decades high. They have to take some steps. But ultimately if inflation does moderate on its own, a couple rate hikes, probably aren't going to make that big of a difference.

Dan Krieter:
Taking steps towards shrinking the balance sheet. That's more meaningful and I think a more risky policy move for the Fed at this juncture. And so I still think that will come at the earliest, you said after the June meeting, I think that would be the absolute earliest. And if that's the case I think the conditions in the credit market should allow for spreads to stay tight. Maybe even narrow a little bit more from the macro perspective before we get into the more meaningful restrictive Fed policies later in the year. Dan, those are the two main tailwinds that I had for credit. Do you have anything else on the tailwind side before moving on to some of the headwinds?

Dan Belton:
No, and I think really to be fair the quantitative tightening is barely a tailwind. I guess you could spin it that way given that it's not going to be a near-term headwind. But you know I think the main tailwind could be a general improvement in the virus situation. Really more headwinds than tailwinds that I'm looking at in the market right now.

Dan Krieter:
Yeah, I think that's well said. I'm not trying to spin quantitative tightening as a tailwind. The fact that it's not coming potentially as early as people are starting to get scared that it would. But you're right. Sitting here there definitely appears to be more headwinds for me from the macro side. You just have this one really powerful tailwind from the COVID story that its strong enough to cancel out sort of all these other headwinds we're dealing with. And obviously turning to headwinds now the main one's going to be inflation. Don't need to wax poetic here, inflation continues to print very, very strongly, the Omicron variant, well good thing for consumption given the domestic picture on Omicron. It's not so clear internationally the impact this will have and will only likely further exacerbate the supply chain issues that we've been dealing with now since the pandemic descended upon the world. And so those inflationary components will continue to be there and ultimately inflation likely to be the most important story of this year when it comes to credit spreads.

Dan Belton:
Yeah, and I think there's some expectation that inflation is peaking right about now and should start to go down. That actually poses to me some more downside risk with respect to credit spreads. If inflation persists again longer than the Fed currently anticipates, that could then increase the likely path of Fed policy rates. And we would be looking at something more aggressive than even another three to four rate hikes that are priced for this year. And I think that's an important point to consider in terms of one of the differences in this hiking cycle from the last one is that, there is upside risk to the quarterly hiking cadence that they did in the last cycle. Whereas, back in 2017 there really wasn't that upside risk because the Fed wasn't fighting off this rampant inflation. Now given that inflation is at 7%, the Fed might have to act way more aggressively than they did last time. And that's just another risk for inflation as it relates to and monetary policy and the impact on credit spreads.

Dan Krieter:
Yeah, and that was under the second significant headwind and you sort of talked about it already, but higher Treasury yields just by themselves typically not a good thing for... We've talked about it many times here on the podcast so we won't go into great detail here but what we've historically observed is that Treasury rates and credit spreads can be inversely related in the near-term. So when we have a near-term move in Treasury rates say higher, we can see that bringing about narrower credit spreads. When you widen the time horizon and look at it from a longer term picture, sustained higher treasury yields almost invariably leads to higher credit spreads. And we don't need to get it into the drivers for that but it does feel like a more sustainable move higher in Treasury yields at this point and that will weigh on credit spreads in the months ahead if it's not doing so currently. And that is a significant headwind for credit.

Dan Belton:
And Dan, just building off of that, one key aspect to the relationship between yields and credit spreads typically has to do with the break down of the move in yields. So when we see break-evens move higher and that leading to higher Treasury yields, that's typically viewed as a good thing for credit because that typically indicates that the economy is going to continue heating, that the Fed is not moving as proactively to cut off stimulus. But what's happened more recently this year is that the move in Treasuries has been almost entirely driven by real yields and not break-evens. That should be viewed as a bearish indicator for credit spreads.

Dan Krieter:
And then finally, a third headwind that's worth talking about here is a fact that hasn't been getting as much airtime in the financial markets as maybe we would've expected and that is the potential for an increase in geopolitical tension. And here we're referring, of course, to the situation in Ukraine between Russia and NATO. Obviously we have no unique specialized view into the situation here, but it does seem like this most recent flare up does seem to be a bit more serious. And most recent headlines on the situation coming out just as we record really is that there has been no commitment from Russia to de-escalate the situation after two rounds of diplomatic talks this week. So if nothing else, this is a lingering risk out there that could end up being a considerable widener if we have a flight to quality if this situation gets worse from here.

Dan Belton:
Yeah, and really over the past couple years with COVID there has been a reduction in these geopolitical flare ups. And this is just kind of a reminder that these types of events really do stand in the background as a potential risk to credit spreads.

Dan Krieter:
Yeah, it's a good point, Dan. Backing up now from the high-level we've talked a bit about the tailwinds and headwinds and credit which I do think results in a pretty neutral outlook for credit and one where technicals play an extremely important role. And that's a major reason why our near-term view on credit heading into 2022 has been constructive for credit spreads.

Dan Belton:
Yeah, so despite the fact that January is typically one of the heaviest months of supply of the year in credit, it's also one of the most constructive in terms of access returns and changes in credit spreads. And so for that reason, we've been expecting some near-term support for credit. And we've gotten that to an extent. Technicals have been a little bit wonky to start the year. We've had exceptionally heavy financial supply and a relative dearth of corporate non-financial supply. So already a strong start to the year. We've had 90 billion priced in just the first seven sessions. About two thirds of that has been financial which is really the continuation of a theme we saw over most of 2021, which is financials have been coming to market much more frequently than non-financial counterparts.

Dan Belton:
There are various reasons for that. I think one being the SLR exemption that we spent a lot of time talking about last year. More recently I think you have these financial borrowers who are trying to front run bank issuance that's sure to come next week after the big US banks report Q4 earnings. So there's just been a mini rush to market from some of these financial borrowers and that's really weighed on demand in the market. So year to date new issue concessions for financials have averaged about five basis points versus one or two basis points for their non-financial counterparts. We've seen similar trends in order book coverage and other metrics for new deal execution. And so primary market statistics is something that we're watching very closely with respect to our near-term constructive view on credit. And we are specifically looking for some of this financial supply to subside in the near-term and be replaced by some corporate non-financial issuance, which we expect will be more readily digested by the market.

Dan Krieter:
Yeah, it has certainly been a bit of a wonky start to the year. Not exactly what I would say I was expecting coming into the year, but at the same time, it hasn't been weak. We've seen demand metrics bounce up and down, and I think you hit the nail on the head. It has a lot to do with whether you're a financial borrower right now, given how much financial supply has come. So I think the outlook will improve from here, but even to this point, it hasn't been bad. Primary market metrics have been okay and secondary spreads haven't really budged. And I think given all that's happening, the shift of the conversation of the Hawk has fed higher Treasury yields. All the headwinds we talked about earlier, I think we have to consider technicals as one of the supportive factors that at least in the near-term, seasonal supportive factors are helping keep spreads where they are.

Dan Krieter:
And I think where they are, it's actually an important thing to say because, and even though we have a supportive UN credit for now, I think we would agree that certainly we expect those headwinds to sort of win out in the long term. And as we wrote it in our 2022 outlook we're expecting spreads to hit the annual peaks likely sometime in Q2. We're expecting a widening event at some point around the midpoint of the year. And those same headwinds will likely limit any near-term narrowing to be just modest. We're not going to see it, 15, 20 basis point narrowing from here. That's not going to happen.

Dan Krieter:
I think to be realistic, probably the most bullish case you could build is a narrowing of maybe 10 basis points. And even then I'd have a hard time getting there. You know, we could see a couple basis points, maybe five basis points ahead of what we expect to be a wider environment in Q2. So if that's the outlook, the question then becomes, should we just wait until Q2 to invest? Should we underrate Treasuries and wait until Q2 to invest in spreads? Or should we, given a stable outlook for the next couple months, should we still be in credit spreads and maybe looking to be more tactical come Q2? And Dan, you did some work on this for our weekly last week.

Dan Belton:
Yeah, so what we did was we simulated portfolio excess returns based on three hypothetical investment strategies and these were overly simplified but I think drove home an important point. The three strategies that we looked at were first, you invest in credit at the beginning of the year and you earn excess returns just based on the broad IG index. And then alternatively you could wait for a 5% or 10% backup in credit spreads buying that dip and then holding that position for the balance of the year. Of course the risk with waiting is that such a dip might never materialize. And then the investor would be stuck in Treasuries gaining no excess returns at all for the year.

Dan Belton:
And over the past 25 years we found that to be the case in seven years. So on average over the past 25 years, when we ran this simulation, returns for investors who invested at the beginning of the year and held for the duration average 1.8% versus 0.3% and 0.6%. And the strategies in which investors were waiting for a 5% and 10% backup in credit spreads. But I think the most interesting finding was this. So out of the past 25 years in nine of them the strategy of waiting for a backup and then investing outperformed in nine of those years. And in seven of those nine years, where it paid to wait for cheapening in credit that backup where the investors saw the 5% cheapening in credit occurred in the first six weeks of the year.

Dan Belton:
So in other words, investors remaining underweight credit, hoping for better levels, shouldn't plan to wait very long. Because while you're underweight credit, you're A, losing carry and B you're also risking getting in at less advantageous prices. And so given that our bearish view on credit isn't one that's likely to materialize, at least in our base case until the second or maybe even third quarter of the year, we think it makes sense to invest in credit now. And then take a more tactical underweight position later on in the year. As we think these headwinds start to mount and become more of a near-term story.

Dan Krieter:
And obviously we will be here each week with you in 2022 to walk us through as the factors change, when that expectation will be. It could be earlier, it could be later, but as of right now, it does seem like the runway is still clear to at least be indexed weighted to credit now, at least for the near-term, as the market as a whole remains in this waiting for inflation environment. It's going to take months to see how the inflation numbers play out. And that's a big expectation for why we think spreads will widen later on this year, but it's not going to be in the very near-term. So Dan, I think that pretty well surmises the view, at least for the near-term here in our first episode of the year. Anything else you want to add before we wrap up?

Dan Belton:
No, Dan, I think that covers it. Thanks for listening.

Dan Belton:
Thanks for listening to Macro Horizons, please visit us at bmocm.com/macro horizons. 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 dot 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 a FICC macro strategy group in BMO's marketing team. This show has been edited and produced by puddle creative.

Speaker 2:
This podcast has been repaired 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.

Speaker 2:
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Speaker 2:
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Speaker 2:
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Speaker 2:
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Speaker 2:
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 it's affiliates may have positions long or short and affect 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 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

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