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An Uneasy Calm - High Quality Credit Spreads

FICC Podcasts Podcasts September 14, 2022
FICC Podcasts Podcasts September 14, 2022

 

Dan Krieter and Dan Belton discuss the narrow trading band in credit spreads which has held despite volatility in financial markets broadly. Other topics include the outlook for fundamental creditworthiness, relatively light issuance thus far in September, and the impact of Tuesday’s CPI report on the odds the Fed can still achieve a soft landing.


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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 September 14th, an uneasy calm. I'm your host Dan Krieter here with Dan Belton as we discuss the remarkable volatility in financial markets in the past couple weeks, as well as the most recent CPI print and what it means for credit spreads going forward. 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.

Dan Krieter:

Well Dan, it's been two weeks since our last podcast and credit spreads are basically unchanged in that time period, trading between 140 and 145 basis points over Treasuries, depending on which index you're looking at. And now obviously there has been some fluctuation in spreads during that time, but volatility has been remarkably low, at least in the context of other financial markets. Credit spreads have been confined to just a six basis point range in the past two weeks, while we've seen a 13 basis point range in the typically less volatile CDX market, alongside equities 5% both higher and lower in the past two weeks.

Dan Krieter:

We're also right in the middle of September supply wave, which is historically the two largest weeks of IG supply in a calendar year. Clearly we have a lot to discuss on today's episode, but I think we have to start by talking about the inflation data revealed this week with core CPI surprising to the upside at 0.6% on a month over month basis, a sharp reversal from the 0.3% growth observed for July. Dan, we'll get to spreads here in a sec, but first the question everyone's asking now, what does this inflation print mean for the Fed?

Dan Belton:

It's hard to paint yesterday's inflation print as anything but bad for the economic trajectory. If you look at the past 12 months or so for the Fed, they really started this hawkish pivot in earnest last November, and that's when Chair Powell abandoned the characterization of inflation as transitory and a month later they doubled the pace of tapering and eventually moved on to these outsized increases in the policy rate. Now, over that 10 months, if you look at core CPI and month over month growth, that has hardly budged after 10 months of near unprecedented hawkishness for the Fed. I think at this point the base case has to be that the Fed is going to air on the side of continuing to be as hawkish as they have been, and that likely means another 75 basis points next week followed by potentially 75 basis points in November. And that clearly means more pain ahead for risk assets.

Dan Krieter:

Putting that into numbers, we have at least now a meaningful probability of 100 basis point hike in September and more material than that is probably who knows when the Fed is going to stop hiking. We've seen this Fed exhibit a desire to stop hiking even in May and June when the Fed was moving to 75 basis point hikes. We had Fed governors, Fed speak coming out. The most memorable for me was Bostic saying September might be a good time to pause. It just shows that there's been this desire from the Fed to front load hikes and then ultimately end the hiking campaign in hopes that a soft landing would be delivered. But for me, and I think for everyone at this point, we're back to square one now with inflation. The 0.3% growth software July now seems, like you said, going back looking at the data, that seems like an outlier now more than anything else.

Dan Krieter:

It's been 0.6, 0.7% month over month almost every month except for July. I think we basically throw that one aside now and the Fed has to return to being fully hawkish to try to get this inflation genie back in the bottle. That means hikes for longer than we were expecting. Obviously, there's been a big debate over what the terminal rate will be now, and we even had Fed governors before the CPI print coming out and talking about a more active role in balance sheet normalization. Fed President George last week talking about the potential for asset sales to normalize the balance sheet to own just Treasuries. Obviously, here she's talking about active selling of mortgages, which was a big topic back in April and has died down. I do think it's on the table that we start to see some more discussion around a more aggressive management lower for the balance sheet. I'd love to get your thoughts on that.

Dan Belton:

Yeah, I think it's clear that the base case now has to be for a higher terminal rate than it was before. I think just a few months ago, if you had said the Fed was going to move Fed funds to a four handle, most people probably wouldn't have viewed that as a base case, whereas now that's what the market is pricing to. And frankly, I think there is still a risk that the Fed has to move higher than that just given how stubbornly high inflation has been. But at the same time, the Fed is very cognizant of the fact that monetary policy impacts the economy including inflation with the lag, and then that lag is probably around six to 12 months.

Dan Belton:

It's possible that while the Fed continues to hike rates at the 75 basis point per meeting cadence into the medium term, that they want to slow down the use of their other tools like balance sheet normalization while they await the impact of this tightening on the economy. I think there is reason to expect that the Fed needs to slam on the brakes here given how high inflation has been, but in order to achieve a soft landing, however elusive that might be, it would probably be prudent for the Fed to slow down at some point early next year.

Dan Krieter:

Yeah, it's an interesting question because you said it, 10 months of the most hawkish Fed policy we've seen in decades has resulted in very little meaningful dent in core CPIs. Obviously, continue hiking rates. I wonder if they have to start talking about alternative rates because this is really the first time that the central bank is dealing with an inflation threat in the ample reserve regime. Could it be that the overwhelming supply of liquid in the financial system is serving to dampen Fed rate hikes to some extent? I don't know if that's true or not. I'm just saying that if I'm sitting on the FOMC, I might be starting to think about alternative methods of trying to get inflation back under control. It would be outside the base case, but it serves to demonstrate the point that the Fed is going to have to remain 100% in inflation fighting mode for the foreseeable future.

Dan Krieter:

And from an economic standpoint, that makes the odds of a soft landing look exceedingly slim if it's even possible at all, because the Fed is trying to turn a massive ship here, and as you said, the lags on monetary policy are uncertain, so who knows how much restriction they've already put on the economy and it's only going to be added to further in the months ahead. We've been on record in saying that a soft landing is going to be very difficult. We're not the only ones saying that, but the interesting thing for me is that credit spreads are not reflecting that in my view at all. And to demonstrate, I'll come back to the yield enhancement of corporate bonds, just looking at what a credit spread is fundamentally. A credit spread is the additional yield that you get for investing in to a company with credit risk. And obviously in investment grade markets that credit risk is low, but at some point in time, you'd just rather own a Treasury, which is why I think it's very instructive to look at corporate spreads as a percentage of Treasury yields.

Dan Krieter:

And after this big move, we've got higher in Treasury yields now in the weeks leading up to and now following the CPI print. We're talking about yield enhancement on the broad IG index of just 40% over 10 year Treasury rates. And at the short end of the curve, it's even more extreme. Two year corporate spreads now add just 19% enhancement over two year Treasuries. Those are both near the lowest levels since the financial crisis and lower than even at any point during the extremely narrow spreads of 2021, just demonstrating the fact that from a relative value basis, you're getting very little compensation for going into a product with credit risk. And there are multiple factors to argue that yield enhancement should perhaps be above average levels instead of well below them. We've talked about the differing Fed response function likely in terms of an economic slowdown. We're not going to see the Fed riding to the rescue likely as they continue to fight inflation. We know liquidity is terrible right now in financial markets, both in Treasuries and in corporate bonds. You can see that in both stress indices in both Treasuries and corporates. Yet spreads are narrow historically relative to sovereign curves.

Dan Belton:

And you don't even need to look at the yield ratio to make that point. If you look at spreads at the index level of 140 to 145 basis points, those are narrower than the long-term average for investment grade credit spreads. And if you look at the risks, you mentioned them, but you talked about credit risk. There's also liquidity risk, and liquidity is a major component of credit spreads, and it's one of the reasons that spreads touched near all time tights in 2021 as the Fed continued to pump liquidity into the system, is the Fed is going to reverse that liquidity injection and start to remove liquidity from the system potentially very aggressively. That's just going to pressure credit spreads wider. Credit spreads at or even inside of long-term tights really just doesn't fundamentally make sense against the backdrop of some real significant macro risks including recession and potentially an increasingly hawkish Fed.

Dan Krieter:

I was about to make the same point because the best justification I can come up with for spreads being so relatively narrow despite the troubling macroeconomic environment is just how much liquidity is in the system which mechanically forces investment out to credit spectrum. But you said it, that's going to change going forward. QT is now at the terminal caps and while outside the base case, I do think it would be possible to see increasing speculation over more active management lower in SOMA as another method of trying to tamp down inflation here. Even that is going to change going forward, and it just seems to me that we're priced to this perfection that we might get a soft landing and the odds of the soft landing are just so low.

Dan Krieter:

But we've been very high level now. Maybe it's instructive now to narrow the focus a little bit and talk about the recent narrowing and spreads and what drove that because it's really been the fundamental side of things that has driven the narrowing that's been mostly prevalent since mid-July. We've seen optimism for earnings in the corporate sector increased by a few different metrics. I'll highlight two here real quickly for the podcast. The first we talked about in a previous episode is just revisions to equity analyst expectations for earnings, which increased on a one month basis from mid-July to mid-August by one of the largest magnitudes on record.

Dan Belton:

I think of that as a relief rally. As second quarter earnings started to come in and the market began to realize that the weakness in earnings that many have been anticipating maybe wasn't coming in the second quarter and ultimately didn't come in the second quarter, that's when optimism about earnings started to really rise. And that doesn't necessarily mean that weakness isn't coming. I think it is going to come later on in the year, but it was probably a little bit premature that there was this pessimism around the likely trajectory of earnings.

Dan Krieter:

And that segue as well to the second metric I was going to talk about, which is the solvency component of B of A's global financial stress index. They have various sub-components and one of them is solvency, which tries to isolate fears over just purely credit. And that, unsurprisingly, saw a similarly large increase between mid-July mid-August, one of the largest increases on record. And even last week in the big market rally ahead of CPI, we saw another significant drop in solvency risk. Now, 50% off the peaks in 2021. And to your point, I don't think we've seen the peak from a credit perspective yet, particularly after the CPI print. I think we're going to see credit concerns continue to grow here and fundamentals after a pretty large improvement in the summer months is going to worsen going forward, which would obviously put upward pressure on credit spreads.

Dan Belton:

And rating actions, we've talked about this on many podcasts before, but I think it's a very important point as we talk about the fundamentals in the high grade universe. Rating actions have been extremely supportive since really the end of 2020, and that's starting to moderate and even turn negative in recent months. For the first month of the year in August, downgrades outpaced upgrades for the corporate universe as a whole. Now, high grade and net upgrades outpaced downgrades in August, but among corporates in general, that wasn't the case. In September, that trend has continued with corporate downgrades outpacing upgrades, and that's even bled into the high grade market. We've seen more high grade downgrades in September than upgrades for the first time really since middle of 2020.

Dan Krieter:

It's a great point, Dan, and just another piece of evidence for me that fundamentals seem likely to worsen in the coming months. Now, offsetting that to some degree has been a pretty significant improvement in market technicals, which we know that technicals have weighed on spreads for the majority of the year, but we've seen the technical picture improve markedly really in the past six weeks. And I think that September supply so far in the heaviest or expected to be the heaviest period of issuance of the year has demonstrated that.

Dan Belton:

Yeah, supply's been very light since Labor Day. We've had about 65 billion price, and today there's only one deal in the market. Some of this weakness was due to yesterday's CPI report, which had a reported, I think, three issuers stand down, only one coming to market today. Just for context, in each of the past three years, the two weeks following Labor Day have seen between 110 and 120 billion in issuance. This year, that period's looking to be around the 70 to $80 billion mark, assuming we get some decent supply on Thursday this week. But one of the reasons that this light supply has been surprising is because the deals that have come have come pretty well received, at least in the context of execution levels that have persisted this year. New issue concessions for the past two weeks have averaged about eight basis points, which is down from the year to date average of 11 basis points.

Dan Belton:

Order books have been a little bit over three times covered on average, and that's also up slightly from 2.9 times for the year to date. We've had a decent improvement in new deal execution statistics, but supplies come in surprisingly light, so it's possible we see some heavy supply persist into the beginning of next week ahead of the FOMC, or maybe it's just the case that supply is going to finish the year on a lighter note than it was at the beginning of the year. And that would make sense for a few reasons, not least of which being the higher great wider credit spread environment.

Dan Krieter:

Yeah, it certainly seems to me at this point that September supply is going to come in far lighter than we expect, and that really continues the trend that has been in place for most of the past four months. We saw a big increase in supply in August, but that looks to be the outlier now. I think that it's clear that September supply is going to fall short of expectations and probably for the remainder of the year that 1.3 trillion estimate that is already revised lower from our initial projection, we might have to revise that lower as well. Looking ahead, at least on the supply side, it seems that technicals are going to be much more supportive going forward. And you talked about the reception for these new deals, clearly demand has increased as well, so at least in the near term demand technicals should be supportive, but I do worry that demand could turn lower.

Dan Krieter:

Once again, obviously we talked about earlier in their podcast with there potentially being increased in credit fears would work to reduce demand, but also after that record outflow from IG funds in Q2, we saw a return to inflows. And I worry now that might be turning back towards outflows. Indeed, we have seen a few outflows, and as we know, typically mutual fund flows follow returns and returns likely to turn negative once again going forward. I do worry that demand side technicals could deteriorate, but at the worst, I think technicals will be neutral for the IG market going forward, at least for the foreseeable future. And maybe that actually works to explain a bit of why we've seen such stability in credit spreads relative to other asset classes with spreads trading in such a small band here in the past two weeks.

Dan Krieter:

You have these competing forces in terms of deteriorating fundamentals and improving technicals resulting in this push pull, which is what we've seen. Looking ahead, Dan, in my personal view, I still don't like credit here. I think just look at the risk reward, it just seems so skewed to the upside for me. If you asked me to build a case for what would be the environment where credit spreads are 20 basis points wider in a month, I could pretty easily come up with a case for that. If you asked me to describe the scenario where spreads are 20 basis points narrower in a month, I don't know that I could come up with one.

Dan Belton:

Yeah, I'm with you there. I think credit spreads do not have a very attractive risk reward profile right now. I do think the case for narrower credit spreads not in the next month, but in the longer term likely relies on a soft landing by the Fed. I just think especially after yesterday's inflation report, that seems like a very remote possibility. And yesterday I think is an interesting microcosm of what you just talked about. We had equities down about 4% on that inflation number. Credit spreads finished the day either unchanged or one basis point wider. It's hard for me to reconcile that just given the macro picture that other asset classes seem to be pricing right now. I think you probably touched on the most important reason for that, which is technicals, but against a backdrop of a very challenging macro environment, I don't think technicals are going to be enough to pressure credit spreads meaningfully wider from here.

Dan Krieter:

So suffice it to say we remain bearish on credit going forward, and we will look forward to hearing what the Fed has to say next week at the FOMC meeting. We will be back here, of course, as we are every Fed meeting with our reactions immediately following the September FOMC next week. Looking forward to that.

Dan Belton:

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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