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Countdown to Kickoff - High Quality Credit Spreads

FICC Podcasts Nos Balados 31 août 2022
FICC Podcasts Nos Balados 31 août 2022

 

Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the upcoming September supply wave and what it likely means for high grade corporate and SSA markets. Other topics include the recent resilience in credit and whether the market is adequately priced to the macro outlook, the Fed’s Corporate Bond Market Distress Index (CMDI), and swap spread seasonality.


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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 August 31st, Countdown to Kickoff. I'm your host, Dan Krieter, here with Dan Belton as we update our view on credit spreads ahead of the Labor Day holiday in anticipation of September's supply wave. We discuss what September supply will mean for credit spreads in both IG and SSA markets, as well as what it might mean for swap spreads.

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.

Dan Krieter:
Well, Dan, sitting here firmly in the quote unquote dog days of summer, the pseudo holiday for the corporate bond markets, it sees primary markets applied dry up and secondary market activity slow down significantly to that point yesterday, qualifying as the third lightest day in terms of IG trading of the year excluding Fridays, trailing only the first day of the year as well as the Thursday before good Friday. So clearly things have slowed down. Market participants are obviously well aware of this little period before Labor Day where things slow down and we get a little bit of a break. But volatility likely to come back in a big way beginning next week once the holiday is behind us. And want to get your thoughts on where you think credit spreads will go there. Because what we've seen in the past couple weeks has been credit spreads actually outperforming other risk assets, namely equities, where we've seen a pretty significant selloff. And while spreads have widened, the widening hasn't been nearly what we'd expect given the magnitude of equity sell off. So I guess we'll just kick it to you. How are you viewing credit spreads as we approach Labor Day?

Dan Belton:
Right. Well you said it, especially since Jackson Hole, credit spreads have hung in pretty well. So credit spreads are about six to eight basis points off the local lows that we saw around the middle of August. And at the same time, equities are down almost 6% if you look at the S and P. So that 6% decline in equities typically would imply about 15 basis points of widening in credit. We've only seen about half that move. And so there's been a lot more shatter about whether or not credit spreads are pricing to the macro realities of likely recession and an increasingly hawkish fed policy that's likely to persist well into 2023 as Chair Powell emphasized on Friday at Jackson Hole. And that's how I'm thinking about credit spreads right now. Jackson hole really to me reinforced the likelihood that credit spreads are going to move wider into year end, just given the macro risks that I really don't think that they are reflecting right now.

Dan Krieter:
Yeah, I'm with you. You mentioned Jackson hole, we can talk a bit about that. I mean, from my view, really this sort of light week that we've got here pre-holiday, there were two things that I'm looking at that will impact my view on credit spreads in the nearer term that it's going to likely to be released this week. We'll talk about both off the top.

Dan Krieter:
The first is obviously just the employment report that we're going to get Friday and what that could mean for the path of the fed. And the second thing is the monthly update to the corporate market distress index, which we actually got this morning, which I view as a proxy for liquidity. So I was interested to see if there would be anything coming out of that we could discuss, and I think there is.

Dan Krieter:
But we can start with the fed and Jackson Hole and the employment report because I'm at this stage now where I'm not convinced that this employment report's going to really matter in either direction. Even if an out sized, miss it's hard to see how Friday's employment report will alter the path to fed policy. It's all going to come down to inflation. We do get another inflation print before the September FOMC. But at this point, particularly after what we saw Jackson Hole with Chairman Powell famously previewing some pain coming for households and businesses, it seems to me that a 75 basis point hike is likely going to be delivered by the fed. Market pricing has increasingly moved that direction where I think 75 basis points is now almost completely priced in. And it underscores what you started to allude to earlier that the fed is going to remain hawkish. Even Minneapolis fed President Kashkari on Monday, talking about how he was happy to see the equity market sell off in response to Chairman Powell's speech at the Jackson Hole meetings because it demonstrated the fed's commitment to this hawkishness the market needs to understand.

Dan Krieter:
And I don't know that credit markets are reflecting that risk at this point. I mean, we're still lower, not only of course than '08 and 2020, but the spread peak in 2022 remains below what we saw in 2011 and 2015, '16 as well. So we're just not at the point where I think the IG market is really pricing in the likelihood that the fed is going to remain much less accommodative going forward in any economic slowdown than we've gotten used to seeing in the last 20 years.

Dan Belton:
Yeah, I mean the ICEB of a corporate index spread of 145 basis points is still about 10 basis points inside of long term average levels, so it's hard to argue that credit markets are reflecting these realities. And there's precedent for this, for credit markets failing to price in the likelihood of recession while other markets are pricing it and having to then play catch up and move wider as these realities come further into fruition.

Dan Belton:
So if you look at the federal reserve bank of New York's recession probability model, which just looks at the spread between three month treasuries and 10 year treasuries and implies some market based probability of recession, there have been four times before the current episode where that probability has moved north of 15%. That was in November of 1997, March of 2000, August of 2005 and November of 2018. And in three of these four episodes, spreads had to migrate wider over the ensuing year as these recession probabilities became more realized. The only exception was November of 2018 when the economy held on and spreads held on for longer than a year, but eventually did move wider as COVID descended on the market. And each of these periods, when the recession probabilities top 15%, credit spreads traded well inside of their long term averages as they are right now. So I think it's pretty clear that the market is not adequately pricing recession, and that's pretty typical of late business cycle pre-recessionary periods, even when other markets like treasuries are adequately pricing to the probability of recession.

Dan Krieter:
It's a very interesting observation, Dan, and it actually segues nicely to the next thing I wanted to talk about, which is the update to the corporate market distress index we got this morning, the Fed's new data series that measures stress in investment grade and high yield markets specifically. And looking at the data from today, the way I interpret it is we haven't seen credit concerns really start to seep into corporate markets yet. And we've talked about this on previous editions of podcasts, talking about how defensive sectors have sort of underperformed our expectation for mounting recession concerns at this point, that defense spreads were still somewhat elevated compared to historical datas and what we'd expect the move to be thus far. And looking at most recent CMDI data, you can paint a similar picture.

Dan Krieter:
So let's just start with where stress is on a historical basis. Because if you look at the CMDI historically, the IG market appears to be under stress. The most recent print, while it has come down, is still at 0.39, which is well above the long term historical average of 0.26. But what stuck out to me that was most interesting is the disparity between where investment grade stress is and where high yield stress is. We just talked about IG stress being elevated. The opposite is true in the high yield market. The fed measures both IG and high yield stress and the high yield index is below the long term average. And this disparity doesn't seem to make a lot of sense. And when we're heading into a potential recession or at least a slowing economy, we should start to see credit concerns mounting, and that would theoretically impact high yield, at least as much if not more, than it does IG. We haven't seen that yet.

Dan Krieter:
And if you look historically, there are two other instances where investment grade stress was elevated compared to relatively subdued high yield stress. And those two instances were 2016 and 2019. Now, what do we know about both of those market environments? Well, both of those market environments featured significant liquidity problems in financial markets. In 2015, 2016, we saw significant selling of US denominated securities out of emerging market Asia and defensive local currencies, which caused a liquidity breakdown in financial markets here in the US. And then of course in 2019 as reserves grew scarce, we saw similar breakdown on liquidity with market makers being unable to intermediate flows. And certainly liquidity is likely a much bigger consideration for investment grade markets than it is for high yield. Obviously the investment grade market is multiples bigger than high yield, but also high yield liquidity is not generally considered very good. Investment grade liquidity is going to be a significant portion of credit spread.

Dan Krieter:
So what that argues to me is that in the current environment, the widening we've seen in IG spreads year to date has been primarily liquidity driven like it was in 2016 and 2019 when we saw this disparity between IG and high yield. If we see credit concerns grow, we should see high yield stress rising like it did in 2008 and 2020 when we see typical credit concerns, and that would lead IG spreads wider. Of course you could also argue this the other way, where if liquidity in the IG market improves, which it began to in August. It did tick lower, not significantly, but it did tick lower. Obviously that would put downward pressure on credit spread. So just from a pure where we are right now standpoint, it's not really flashing in a bearish or bullish signal to me. I just think it's an interesting observation that the widening has been liquidity driven thus far and the near term direction of spreads will depend on the evolution of credit concerns. And in my view, I think that's going to increase as the reality sinks in that the fed is going to remain hawkish and the economy continues to slow.

Dan Belton:
Yeah, and I think that underpins how we've been thinking about credit markets for a while now, which is that the longer term path of credit spreads is likely to take its queue from fundamentals. And credit rating actions have turned from extremely positive over most of 2021 to roughly neutral now. They've really moderated and they're sitting around neutral, maybe net constructive overall. But that's really going to determine the next leg in credit spreads, whether the economic slow down that many are predicting starts to feed into rating actions potentially sooner, rather than later, as we could potentially see Q3 earnings start to illustrate the potential downside to corporate fundamentals.

Dan Krieter:
So I think it's safe to say at this point, Dan, that we maintain our bearish view on credit spreads in the median term, expecting another leg wider here in late Q3, early Q4 as fundamentals maybe begin deteriorate a little bit. But for the rest of the episode, Dan, I think we have to focus on September supply and the technical picture, which is going to become front and center in the market spotlight here as early as next week when the September supply wave arrives. We know that in IG markets, September is actually the biggest month of the year, even surpassing average supply during January. So technical is certainly likely to take the steering wheel here for the next couple weeks, Dan. So let's start just very high level with September supply. What has September supply historically meant for credit spreads? We know that investors are typically set up for it, so does September supply typically result in widening as we see that supply get digested? Or do we see investors ready to take down supply readily and spreads actually perform?

Dan Belton:
Yeah, it's interesting. And when you look at September supply, I think the most informative portion of it to look at is the first two weeks after Labor Day. So that's when typically most of the supply comes, that's the window just before the September FOMC, and that's how the calendar sets up for this year. So we have the really nine sessions between the Tuesday after Labor Day and the end of the following week where we're expecting the vast majority of September supply to come. The following Wednesday the 21st, is when the fed announces its policy rate decision. And given the uncertainty surrounding that meeting, we don't even know right now if it's going to be a 50 or 75 basis point hike. I'm expecting issuers to really avoid much of that week. We'll probably get some amount of supply, but really nothing like we're going to see in the first two weeks of September.

Dan Belton:
And so when you look at historical spread performance during those two weeks, we actually see that the investor set up for that supply overpowers the technical widening influence of the supply itself. So if we go back and look at spread performance during that two week period over the last 10 years, we find that spreads have actually narrowed in seven of those years and widened in only three of them. The average spread move is about 2.4 basis points narrower over that two week period. And we've seen spreads move narrower in each of the last five years in the two weeks following Labor Day. So it does seem like even though this is the heaviest supply period of the year, investors are set up for it. They're expecting it, and there's a lot of dry powder and they're able to take down supply very enthusiastically. And so we'll see if that remains the case this year, but I think it bodes well for how we're expecting some of this early supply to be digested in September.

Dan Krieter:
Yeah, I think that's very interesting data. And it is worth noting that this year's September supply is expected to be kicked off by a few large M and A LBO related deals, specifically a deal from Citrix is expected on Tuesday that could be about 15 billion in size. And we do typically see some concession for these larger jumbos, which could maybe start the reception off on a bit of a weaker tone. But as you say, Dan, investors are set up for it and certainly they're expecting this jumbo deal from Citrix as well. So we'll just have to see if this year is as a continuation in the pattern of spreads narrowing through very heavy September supply or if we get the opposite reaction this time given a more challenging macro environment than we've probably seen in any of the past five years at the September point in time. And before moving on to more specific technical considerations, and I did also want to ask about the impact on swaps spreads we typically see during the September supply wave. You'd think obviously with heavy issuance, we would see more swapping of that. But again, people are expecting it so maybe there's some front running of it. Did you look at swap spreads at all and see how those typically perform during September?

Dan Belton:
Yeah, so we do see swap spreads sort of front run this supply a little bit. We start to see narrowing in swap spreads on average begin the week before Labor Day and then persist into Labor Day week. And then the week following Labor Day, even though that second week of September still brings heavy supply, that's when the move starts to reverse. And that's when we like to at least tactically get long swap spreads is the week following Labor Day, when even though there is still that heavy supply, the move has kind of already started to reverse and then swap spreads move wider into the end of September, at least on average.

Dan Krieter:
Yeah, so I think our long term view on swap spreads are made to be positioned for continued narrowing in swap spreads, particularly alongside quantitative tightening, which is going to start mattering much more now come September when the fed hits its full runoff caps. But we could see a bit of a short-lived widening there, which you can take advantage of tactically or just look to sell/take profits on swap spreads toward the middle part of September and intuition more medium term narrowing.

Dan Krieter:
Well now we can turn the conversation back to credit spreads. Just wanted to make a quick note on the high level impact of supply on swap spreads as well. So now let's maybe look more specifically at this year, Dan. Obviously we saw a very heavy August, at least up until the last couple weeks, the heaviest August on record except for 2020. So as we approach September, are you expecting corporate supply to remain quite elevated? Looking back at previous Septembers, the average supply is about 150 billion since 2016 in September. What's the risk to that estimate in your view? Are you expecting heavier or lighter supply than that one 50 billion mark?

Dan Belton:
Yeah so as I said, we're expecting it to be very front loaded. We'll probably have a pretty good idea of whether supply comes in heavier or lighter than expectations by really the end of the first or second week of the month. And we're expecting supply to continue to fall on the heavy side of historicals. We're forecasting about 160 to 165 billion in supply on the month, and that's really driven by an expectation that there is this pent up issuance demand that we're seeing in the market, and we're seeing it through two avenues. First, we've seen an increase in reliance on short-term funding among the corporate borrowers we track. We've seen an increase in commercial paper among nonfinancial borrowers. We've also seen an increase in CNI bank loans, which those can be taken out by a variety of corporations, but it does reflect increased borrowing needs among corporates at a macro level.

Dan Belton:
Second, we've seen a strong reduction in borrowing from triple B rated corporations. And as long as market tone continues to firm here into September, we're expecting some of those borrowers who have been really deterred from coming to market are likely to issue in the IG market, maybe making up for some lost time. So this year, only 40% of high grade supply has come from triple BS. That's down from an average of about 47%. And if you look at new issue concessions and really all new issue execution statistics by rating, it's clear why that's been. We've seen triple B's have to pay up several basis points on top of the levels that single A, double A, triple A borrowers are paying up in primary markets, and that's just deterred a lot of issuance from this lowest rated rung of the high grade borrower universe. And so if market conditions allow, we're expecting those borrowers to come back to market in force, and I think September could be an opportune window for them to do that.

Dan Belton:
Obviously there's a downside risk to that forecast of 160, 165 billion in gross issuance. If market conditions don't allow for this heavy supply as was the case for much of 2022, that forecast is not likely to be met. But in our base case, we're seeing heavy supply to continue at least in the early part of September, so look for that.

Dan Krieter:
Yeah, I think you made the key caveat there. Borrowers want to come to market, but they don't need to come to market. So if conditions turn sour, they're not going to just be flooding the market with supply and getting it done at any level. They'll be opportunistic. So whether we see supply exceed or fall short of the 150 billion average is really going to depend on market conditions. And maybe that's stating the obvious to some extent, but I think in 2022 in particular, that's going to hold very true.

Dan Krieter:
Now before wrapping up then, I do also want to talk a bit about technicals in the SSA space specifically. Coming off of the lightest July in the history of the SSA market essentially, we did see supply pickup in August. We got net supply of 5.5 billion in the SSA market in August, which was actually the heaviest month since October, 2021 in terms of net supply, including even January. So we did see SSA borrowers start to come back. I think part of that is because in aggregate calendar year funders were and actually still are running slightly behind their pace and in time is sort of running out now that we're getting into September, a couple months of issue and left. So we're starting to see more supply on the SSA market. Looking ahead to September, I think that's going to be sustained. We're projecting 29 billion in SSA supply in the USD market. And for September, that's slightly heavier than average, but not totally outsized. I think cross currency bases are certainly on sides for issuance in the dollar market. And like I said, calendar year funders are slightly behind their pace, but that's offset to some degree by March and June fiscal year end borrowers with much smaller borrowing programs this year offsetting that borrowing need for calendar year funders.

Dan Krieter:
So it's kind of a neutral signal there and cross currency bases on sides gives us a bit of a heavier than average projection for the month. It's also worth noting that even with the IG market essentially closed all week this week, we have seen some issuance in SSAs. We saw NIB with a five year yesterday, OKBs in the market today, and the deals are going pretty well. Now it's worth noting concessions remain at least slightly elevated compared to the historical experience in the SSA market. So I would expect to see some concession, at least on those first few deals coming from SSAS in September. And then it will depend on deal reception to see whether or not those concessions go away or if we're going to see borrowers continuing to need to pay up to place that in September.

Dan Krieter:
But from a high level in the SSA market, technicals may actually slightly improve a bit in September, despite the heavy growth supply. I see a bunch of redemptions as well. So in SSAs and potentially in IGs as well, we're seeing a mostly neutral impact coming from the huge supply in September. Investors are set up for it. And it's not going to be technicals that drive spreads in our view, it's going to be fundamentals and that's going to play out with economic data coming in, inflation data, the path of the fed, things of that nature. That's what's going to drive spreads to September, not technicals, despite the heavy supply. Anything else before we wrap up for this week, Dan?

Dan Belton:
I think that covers it. Thanks for listening.

Dan Krieter:
Have a happy Labor Day, everyone.

Dan Belton:
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 a 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 Directeur, Stratégie sur titres à revenu fixe
Dan Belton Vice-président - Stratégie sur titres à revenu fixe, Ph. D.

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