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Variant Volatility - High Quality Credit Spreads

FICC Podcasts December 01, 2021
FICC Podcasts December 01, 2021

 

Dan Krieter and Dan Belton discuss the recent move in credit spreads on the back of the Omicron variant and the hawkish turn by Fed Chair Powell. They conclude with a discussion of issuance projections in 2022.


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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 December 1st. Variant Volatility. I'm your host, Dan Krieter, here with Dan Belton. As we discussed the Omicron variant and what it means for credit spreads that have widened significantly in just the past week. Finally, we touch on a few projections for next year regarding gross and net supply and high grade markets for 2022.

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 [inaudible 00:00:40]. The topics that come what 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, it's affiliates or subsidiaries.

Dan Krieter:

Well, Dan Thanksgiving sure seems like a long time ago. It was actually only less than a week ago. And in the week since our last podcasts credit spreads have continued to widen and we have two, what you could probably call view changing factors that have hit the tape in just the last week. Obviously the Omicron variant, as well as the Fed's hawkish turn. But why don't we just start with a quick catch up on what's happened in credit markets in the past week?

Dan Belton:

Yeah, so spreads cemented their worst month from an excess returns perspective. Since March of 2020, they turned about negative 1.05% in November, they widened about 14 basis points. And like you said, that was due largely to two factors, both the Omicron variant and chair Powell's more hawkish turn, which he really laid the groundwork for the fed to double its pace of tapering at the December meeting, which would end purchases likely in mid-March. Now it's hard to tell how much of this widening is due to each of these factors. On Friday, the Omicron variant really came into focus, but Friday was such a light trading day. So it's hard to know how much of the volatility was due just to light trading volumes. Trading volumes on Friday were only about 20% of the year to date average. And we had a decent rebound on Monday, which was quickly wiped out in early trading on Tuesday, and then chair Powell's comments in front of the Senate really sent risk assets, even lower.

Dan Krieter:

Yeah and this falls in line with what we've been talking about in our podcast here in our written work for the past few weeks and actually months at this point. We moved underweight credit early to mid-October at the expectation, the credit spread to start repricing to a new plateau to arrange it would more accurately reflect some of the risks facing credit marks, particularly on the inflation side and the fed's reaction function to that.

Dan Krieter:

Obviously that's been half of the move we've seen in the past couple weeks, the other side, being the Omicron variant, not necessarily in our view, but you have to consider that a risk that's been well known to the market, just hanging over our heads now and will continue to for the foreseeable future. So I think this move is mostly in line with what we were expecting. I think now we have to start turning our heads to at what point will credit spread stabilize and potentially even begin to move lower because after the 14 basis points widening that you alluded to, we are near the highs and spreads for the whole year, not just the narrow range since Q1. We're knocking on the door of a hundred basis points on the Bloomberg IG index and obviously heavy supply of January, right around the corner, which a lot of times we actually see spreads narrow through that, not widen.

Dan Krieter:

So, we're at a bit of an influxion point here. And so I figured we have to have our discussion today center on really where will spreads top out, both in the near term. And then maybe looking ahead to 2022 as a whole. So for that discussion, I think it makes sense to start with talking about the Omicron variant, Dan, and I'll kick it over to you here. How has the Omicron variant changed your perception of the market and of credit spreads?

Dan Belton:

Yeah, so I think you made an interesting point earlier in which you said that wasn't part of our view for preferring wider credit spreads some new variant of the virus, but in the backdrop of elevated inflation and potentially worsening inflation in response to this virus, when we see these bottlenecks probably be worsened by increased lockdowns globally, and then also the limited effectiveness of further stimulus in combating the virus without worsening the inflationary outlook. I think that's what really has sent risk assets lower over the past week.

Dan Belton:

So with respect to the variant, obviously we're not experts in this realm, but it does feel like a lot of the headlines that have come out are more on the positive side that most of the symptoms with the Omicron variant are more mild than other variants of the virus. And even if vaccines do lose effectiveness, it's likely that we're going to have some better vaccines available in early 2022. So I don't think that the variant itself is going to send risk assets sustainably lower, but the proliferation of variants in general and how this can cause elevated volatility for a long period of time and lead to renewed lockdowns each time that a new variant pops up. That's going to weigh on the outlook for risk assets for a longer period of time. And then in the backdrop of this removal of accommodation, I think that's going to cause a more direct and sustained weakness and credit spreads and risk assets generally.

Dan Krieter:

Yeah so, like you said, we're not experts, but we have to try to gauge the impact of the variant where we can. And for me, the impact does fall on the inflationary side, at least speaking in the United States. I really don't think that we're going to be at any risk of more lockdowns, particularly like you said, currently, it looks and we hope this is true, that the crime variant results and potentially milder symptoms. And so I really don't think it's going to have much of an impact at all on the consumer or anything here in the United States or consumption patterns where it may have an impact is like you said, abroad where we could see more lockdowns and supply chain bottlenecks. My personal expectation for inflation was that it would begin to moderate towards the middle of the year, just as this one time extraordinary deployment of savings as a result of a few factors during the pandemic.

Dan Krieter:

Once that ended in some of the supply chain bottlenecks started to clear up that we would see inflation come down. I now feel less certain about that. It's very difficult to have good visibility into the supply chain issues or really know for sure, but it does seem like they could linger for longer than maybe I was initially projecting. And so if you, and I agree that the primary concern arising from the Omicron variant at this point is on the inflation side. What does that mean for credit spreads? Because we've long identified inflation as the largest threat to credit spreads. And here we're saying inflation is the major risk from the variant. So does that not mean that credit would likely continue to widen?

Dan Belton:

Yeah, so I think stepping back for a second, I know chair Powell retired the word transitory with respect to inflation, but I still think that the inflationary dynamics are not something that are going to be permanent here. It's going to be more of something that while the Omicron variant might extend the length of inflation here, it is still something that's going to go away on its own. Just as long as the supply side bottlenecks work themselves out. We still don't have significant evidence of this wage price, wage spiral, which would to sustained inflation that the fed would then have to start fighting. However, yes, like you said, if inflation is sustained and persistent into the end of 2022, that should weigh on corporate profitability and credit spreads as a result, it's going to ultimately depend on the health of the consumer. We've talked a lot about the health of the consumer going into next year.

Dan Belton:

Consumers have really drawn down on a lot of their excess savings accumulated during the policy responses to the pandemic through stimulus checks, elevated asset prices, and also just an inability to spend money during COVID lockdowns. So as the consumer continues to draw down on savings and experiences, some weakness it's possible and likely that corporations are going to start to struggle to pass on these elevated costs to the consumer. That's going to eat into profit margins and reduce profitability. Now through third quarter, corporate earnings corporations saw their profit margins modestly higher year to date. And that's mostly due to the strength of the consumer. The question now, becomes, how long will that persist? And if it doesn't, what's going to be the impact on credit and it could become a pretty important story into next year.

Dan Krieter:

Yeah. You brought in the fed, which I think is now the key point. It's obviously the other major factor this week, we led the podcast with talking about Powell's hawkish turn. And I think when you combine the fed's reaction function with inflation, that's where we really need to be focusing, because I think obviously the fed and global central banks around the world are taking a much more hawkish view on inflation here. And the question I have for you, Dan, is this type of inflation, the kind of inflation that the fed can fight. And I'll let you answer it in a second, but I'll just maybe tease out what I'm going for there. Supply side inflation, at least from a textbook perspective may not be affected by any central bank action. So all indications of the fed is going to move aggressively to counteract inflation.

Dan Krieter:

What's less clear to me is that their actions are going to have any impact on inflation. Instead, it may simply work to weaken the consumer. And you talked about the importance of the consumer just a bit ago. If you see inflation continuing to run high from the supply side, which the fed may not be able to really have much impact on, but then more hawkish policy, constraining business investment, and consumption at the personal level, a static inflationary picture begins to develop.

Dan Krieter:

Now, I don't to say I'm expecting stagflation. That's a very specific economic outcome that is very difficult to arrive at, but these are the ingredients for stagflation here. And that is for sure a worst case outcome for corporate profitability. So like you alluded to, I do think we could get another considerable move wider in credit spreads, potentially even are 20-30 basis points from here. Now I'm not saying that's going to happen in a straight line. I think we could see some stability in credits spreads before another leg higher. And we'll talk about that, but I don't think we're at the top yet. If I look out over the entirety of 2022.

Dan Belton:

Yeah. So Dan, going back to your question about, could the fed reduced inflation through their tools? I think the answer is yes, they could. I mean, the current inflation that's going on right now, even though it's mostly supply side driven, it's just a result of supply and demand being out of balance. So the fed could raise interest rates to reduce demand, and that would likely bring inflation lower. Does the fed want to that? Probably not. It's not really worth it for the fed right now to lower demand at this point in the business cycle, just because of these supply side bottlenecks. They could, but I don't think they would. So what the fed is doing right now is I think they're speeding up their taper because when you step back and look at it, the economy's very strong right now and quantitative easing at this point in the economic cycle, doesn't really make go a whole lot of sense.

Dan Belton:

So the fed is likely going to end quantitative easing as soon as they reasonably can and then reassess and see where inflation is, see where employment is and likely remain on hold for at least a quarter or maybe a couple quarters and see what their dual mandate looks like. With respect to stagflation. I still don't think that we're at risk of having the negative growth portion of stagflation really arise. I think we could see some slowing growth and we could be at a point where it's something like in the years following the financial crisis, where the economy muddles along and that coupled with heavy inflation that's going to reduce some of the policy options, but I don't see anything resembling the stagflation that we saw back in the seventies, rearing its head this time around. I just think the consumer is strong and I think we're going to continue to have positive, even if it's slower growth than we've had in the past couple quarters.

Dan Belton:

Now I agree with you. I think credit is going to face a pretty challenging environment into year end. We're going to have a potentially tumultuous December FOMC meeting. We have the debt ceiling, which is going to potentially get contentious over the next few weeks. And all of this is going to happen in a backdrop of a very crowded supply window as issuers continue to rush to market this year, while they still can. So I think we're going to see a challenging environment into year end, but then I am expecting stability at the beginning of 2022, as we have investors waiting around to see these better levels that are likely now going to be realized at the beginning of the year. And there should be some demands to anchor credit spreads in the beginning of 2022.

Dan Krieter:

Yeah. Dan, I'm with you on that view. I definitely think that the remainder of this month will be challenging. I think we'll get a few basis points in more widening, nothing super dramatic and nothing like the 20, 30 basis points in further widening I talked about before. I'm not expecting that in the near term. I think we will get a patch of stability likely toward the end of this year. Really once the FOMC meeting is in the rear view and volume starts to drop. And then into the beginning of next year, I think we'll find some stability, maybe even a pocket of spread narrowing there, maybe a bit counterintuitive given the amount of supply that comes in January, always the biggest month of the year, but seasonally, January actually a pretty good month for credit spreads as investors all come back to the market and are putting on their trades for 2022?

Dan Krieter:

We tend to see spreads perform pretty well in January. I think that'll be repeated again in 2022, we're going to have some of these more negative headlines in the rear view. A hundred basis points or so on the index is going to be a somewhat important psychological level. I think we're going to get some optimism here that the worst is behind us. There will probably be some positive momentum, if we're correct that Omicron, maybe some of the fears there start to fade.

Dan Krieter:

That should give a tailwind to credit in the early part of the year. I think we'll see some spread narrowing. And then I think looking further into 2022, say maybe around the second quarter or so where we're maybe seeing some evidence of the consumer, maybe not being as strong with savings now depleted, inflation still running potentially rather hot. I think we could start to see some more inflationary or even I'll say stagflationary, I know that you won't agree with me, but some potentially stagflationary concerns with the feds continuing to be hawkish. And then I think you could see that other leg higher in credit, maybe around Q2. So I think near term, we could see what maybe another five basis points or so in spread widening, but I think we're near the local peaks here in credit and we won't get that next leg until further into 2022. Do you have any major disagreements there?

Dan Belton:

No, I think we're on the same page there. I think a couple more basis points, but certainly nothing significant in the year end. And then I could see spreads being more anchored at the beginning of next year.

Dan Krieter:

And then this is potentially a decent transition to the rest of what I want to talk about in the podcast today. And it's the technical outlook for 2022. I think that could also be something that weighs on credit spreads over the course of next year. Maybe not necessarily in January, but over the course of the year I think we could start to see supply having an impact on credit spreads as well. Sort of just a constant, minor drag on spreads. So maybe Dan I'll kick it to you. Why don't you give us a brief two minute synopsis of IG supply this year and then maybe what we're expecting year?

Dan Belton:

Yeah. So IG supply from a gross perspective is set to finish this year around 1.45 trillion or so. Which is the second heaviest year on record, only behind last year. And it's pretty significantly above the X 2020 high of 2017. On the other hand, net issuance has been much more moderate this year. We're expecting the IG index will grow only about 7% from last year and that's pretty much in line with, or even below the post financial crisis average. Obviously this disparity is due to both refinancing and heavy liability management activity by corporates. Liability management in 2021 has actually surpassed that of 2020. We see among all corporates around 500 billion of tenders and open market repurchases of corporate debt in the US dollar market. Heading into next year, we're expecting gross issuance to be right around or maybe slightly below levels of 2021 while net issuance should move moderately higher.

Dan Belton:

So we're going to see less refinancing activity because corporate yields across the curve are well above their lows that we saw over the past couple years. So that's going to be something of a drag on gross issuance, all [inaudible 00:16:25] but net issuance, when you look at it from a business cycle perspective, the beginning of an economic expansion is typically when net issuance is among its strongest. So we had a contraction in 2020, of course, and that was a very strong period of issuance as it typically is. We characterize 2021 as a recovery period, which is when there's typically more of a focus on de-leveraging. And in fact, as we discussed on this podcast in recent weeks, corporate leverage is now below its level just before the pandemic. So even though gross issuance was high in 2021, there was a significant de-leveraging effort that was going on for most of the year.

Dan Belton:

We expect in 2022, that's going to shift to more of a positive net issuance focus, and we're going to see corporations start to reinvest in CapEx and other M and A activities. And that leverage is going to start to increase again in 2022, specifically, a couple other factors that we think point to higher net issuance, corporate cash holdings have run down somewhat, and they're going to continue to run down, but corporations are going to start to add to their war chest by raising debt. They're also likely to raise cash for stock buybacks, which are likely to continue to grow from 2021 and then M and A activity should remain strong in 2022 coming off of its record year of 2021. So just to put a bow on it, we're expecting something around 1.35 trillion in gross high grade corporate issuance in 2022, and then an IG index growth of around 8 or 9% from this year.

Dan Krieter:

And that increase in net issuance is really what I was referring to where I think that net issuance is actually arguably what has a larger impact on spreads than gross issuance? Net issuance is obviously just where we need to find new borrowers. So not just reinvestment. So I think net issuance can actually have even a larger impact. So even if issuance next year is going to be, it's going to be in the context of 2021, it could be slightly higher. It could be slightly lower depending on just how much refinance activity takes place, but it's going to be in the context of it. But I think that increased net issuance is what could have more of a drag on and spreads next year as compared to this year. And then Dan, before moving on, why don't we just spend a couple minutes just talking about where the forecast could be wrong, how could issuance be either significantly lighter or significantly heavier than this year? And why don't you start with how issuance could be heavier next year than this year?

Dan Belton:

Well, I think the obvious is if we saw a reduction in corporate yields that could bring on even more refinancing, which we aren't really accounting for much of in our projection. So, that's the main one. We could also see upside surprises to M and A activity to stock buybacks. I think either of those could result in heavier corporate issuance than expected.

Dan Krieter:

And then I guess I'll just quickly tackle the lighter issuance and that it's just the inverse. Obviously it would be that we'd have low refinancing needs and that net issuance would not meet our expectations and to see corporations continue to delever, I don't think that's going to happen given the important role that leverage plays for most corporations these days. But I guess it's possible if we saw net issuance really disappoint, then supply could be lighter than this year. And then Dan, before wrapping up here, I thought we'd just spend a minute talking about issuance in the AAA space in the markets that we cover, SSA agencies. I won't spend too much time here. We'll take them all as from a sort of high level, but issuance in the US dollar high grade market this year fell just short of our expectations.

Dan Krieter:

We were calling for around 300 billion in US dollar SSA supply. It ended the year closer to 270, and really there wasn't much to point to for reasons why the estimate was high from a cross currency basis or anything other than simply borrowing programs did not grow as much as we expected them to grow in our outlook at this time last year. And obviously most of the calendar year funders we knew, but some of the other ones, the big world bank funders with fiscal years that begin in July and some of the Canadian and Japanese borrowers with fiscal years that begin in March. We didn't know borrowing program details at this time last year. And we did not see the increase we expected rather SSA borrowing programs, more held steady with the revised 2020 borrowing programs then continued to increase.

Dan Krieter:

So that came as a bit of a surprise to us. And that's why our projections were a bit higher than what actually ended up happening. But even at 270 billion in US dollar SSAs, that gets us positive net issuance, not nearly as large as 2020, but a departure from the trend in the years heading into the pandemic. And looking ahead in 2022 we expect issuance to continue to fall from a gross issuance basis. Borrowing programs will continue to shrink likely not meaningfully in 2022, but they probably won't be as high as they were in 2021. And we could see net issuance drop into the flat or maybe even slightly negative arenas. So looking at the high quality space in general, in the AAA sector, it's already hard to come by AAA rated spread products with really any spread to treasury.

Dan Krieter:

It's not going to get any easier in 2022, obviously Fannie Mae and Fred Mac did not issue a single benchmark bond this year. Maybe they come back a bit next year, but obviously their issuance patents are not permanently changed. They're not going to be meaningful borrowers. They may well, again, be zero. We don't know, but SSA borrowers looks like we'll have net supply rather run zero potentially negative next year, and same for [inaudible 00:25:19] and covered bonds.

Dan Krieter:

So an asset class that already has very, very tight spreads, at least partially due to the fact that supply is very dear in these markets. That trend is going to continue in 2022. And Dan, I think that's all we have for today and on a bit of a programming note next week, we will be off in High Quality Spreads podcast. We have a recording with the whole team in one of our Monthly Macro podcast recordings next week. So we'll be back with you on December the 15th, same day as the fed meeting. And we'll be back with our immediate takeaways from that. What's shaping up to be very important meeting right after they conclude the press conference.

Dan Belton:

Thanks for listening.

Dan Krieter:

Thanks for listening to Macro Horizons, please visit our 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 scribe 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 has the burned 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 a suggestion that any investment or strategy referenced here in may be suitable for you.

Speaker 2:

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Speaker 2:

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

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