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Attitude Adjustments - High Quality Credit Spreads

FICC Podcasts June 23, 2021
FICC Podcasts June 23, 2021

 

Dan Krieter and Dan Belton discuss three major adjustments impacting their markets in recent weeks. First, the Fed’s changing outlook on inflation including the risk inflation is higher and more persistent than expected. Second, they discuss an adjustment to the IG index controlling for credit quality and duration which shows in spreads trading well within all-time tights. Finally, they discuss the impact of the Fed’s technical adjustment on the front-end.


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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 June 23rd, Attitude Adjustments. I'm your host Dan Krieter, here with Dan Belton as we discuss three important adjustments to our view on financial markets in the past couple weeks and what they may mean for the near term path of credit 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 U.S. dollar swap spreads and all the factors that entails, including funding markets, cross-currency markets and the transition from LIBOR to SOFR.

Dan Krieter:

The topics that come up most frequently in conversations with clients and listeners form the basis for each episode, so please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg, or email directly at dan.krieter K-R-I-E-T-E-R @bmo.com. We value and greatly appreciate your input.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Dan Krieter:

Well, Dan, the theme of our podcast today is adjustments. I think the first one that we have to talk about is the adjustment to Fed rhetoric that was revealed last week in their FOMC meeting, where they delivered a bit more hawkishness than I think we, or the market was expecting. Get us caught up on how financial markets have responded in the week since the FOMC meeting.

Dan Belton:

Yeah, so, the primary reaction was a significant volatility in the Treasury market. We saw a flattening of the fives, thirties Treasury curve last week, by more than it had flattened in any week in about 10 years. Equities have held in fairly well, we saw a bit of a down trade at the end of last week, but a quick rebound in early trading this week. Equities remain near their all-time highs.

Dan Belton:

Then, credit spreads have not really reacted very much at all. They opened, today, about one basis point narrower than they were before the Fed's meeting last week. Just a couple of basis points off of cyclical tights. I think that just goes to show that there is significant risk to this inflation outlook, but it's really early on in the process. We're nowhere near the point yet where we can conclusively say that the Fed is behind the curve on inflation right now.

Dan Krieter:

You're a bit more generous than I am, describing the equity market performances last week as holding in relatively well. I think it was the worst week in stocks since October, but I hear you on the recovery on Monday. For me, I think the main takeaway we talked about in our podcast last week, we talked about our main takeaways from the FOMC meeting.

Dan Krieter:

I think our bottom line was really that the Fed sort of surprised us, by implying a potentially weaker hold on inflation than they had in previous meetings. Using terms like, "Inflation could be higher and more persistent than we thought." Things of that nature. So, I agree with you from a high level, that what we really took away from the Fed meeting last week was that there is downside and risk assets, if, ultimately this Goldilocks path that we've been harping on for the past few weeks, ultimately doesn't hold.

Dan Krieter:

I mean, the power flattening, the Treasury curve, that makes sense. If the market interpreted the FOMC meeting, the way we did that. But, the Fed implied a bit of a weaker hold and then, that implies that the Fed would have to then move quicker and more forcefully in the future, which should flatten the curve. That's what we saw.

Dan Krieter:

This week's has been a bit of a undoing of that, because to your point, things are still too early to say, we saw Powell in front of the Senate yesterday, was a bit more dovish and we've seen a recovery in equity markets, at least. Credit spreads and bond markets haven't really moved.

Dan Krieter:

So, I think the market's reaction that you talked about, it at all makes sense, if the market has sort of digested the Fed the way we did, that inflation is really going to be at center stage. We still don't really know. So, the neutral reaction in credit, maybe not very surprising, but when you fit that into our view, we've been very consistent since March, with this neutral view we've had on credit. Has that changed at all for you, in the wake of the Fed meeting and the market's reaction since?

Dan Belton:

No, it hasn't really changed, but I think it just strengthened what we've highlighted here in our written work for a long time. Which is that the risk/reward profile for credit, right now, is looking a little bit stretched.

Dan Belton:

While we could envision a scenario pretty easily, where spreads move 15, 20 basis points wider, it's hard to see a similar magnitude of out performance in credit right now. Given Paolo's admitted uncertainty, with respect to the inflation outlook, that just presents another risk. Like you said, another possible derailment from this Goldilocks path of recovery.

Dan Krieter:

So, looking at it from a timeline perspective, we've held a neutral view. Expecting to maybe see a bit of a backup in spreads that we view as a buying opportunity at sometime in the summer months. I think, to your point, that you didn't change from the Fed, but I think it has been strengthened. You look forward to the July, August time period, when economic data is going to, theoretically, start becoming more relevant.

Dan Krieter:

We've seen unemployment numbers sort of stay on that Goldilocks path. We'll wait for the next print. Inflation has been high, but that's been expected. Now, we're going to find that if it's transitory. So, in July and August, you have more meaningful economic data, which has to be viewed as a threat to the Goldilocks assumption right now.

Dan Krieter:

You have a seasonally difficult time for credit spreads. If you look at seasonal fluctuations of credit spreads, there's usually very little seasonality that can be observed. That would make sense. Obviously, the majority of time credit spreads are trading off the macro narrative, which doesn't endure over multiple years. But, one of the few pockets of the year where you can see significant seasonality is in mid-Q3. Late July and into August, where you see some weakness in credit spreads.

Dan Krieter:

I think that that's for a couple reasons, the most important of which is the expectation for heavy supply. Obviously, supply comes back in the fall after a summer lul. You have some investors looking forward to that supply. Maybe being able to put cash to work in the primary market instead. Then, you also have just the reduced liquidity of the summer months. Dealer inventories may be getting stale, spreads backing up a little bit.

Dan Krieter:

There is a pretty observable seasonal trend there, in mid-Q3, which is going to intersect kind of perfectly with economic data starting to matter more. So, with that perfect intersection, I think you could see a buying opportunity. Then, the final piece of the puzzle, for me, and in-keeping with our theme on adjustments, is how narrow credit spreads are.

Dan Krieter:

We all know that spreads have moved to post-financial crisis lows here in the past couple of weeks. But, if you look pre-crisis, there are periods of time where spreads were at least optically narrower. But, you did some work, Dan, on adjusting the credit index for compositional changes that may alter the view on where credit is right now. What'd you find?

Dan Belton:

Yeah, so basically the IG index is significantly different today than it was when it was first established in 1997. There's two primary structural changes that have happened in the index that we looked at. The first is the duration. So, when the index was first established in 1997, and here I'm talking about the ICE/BAML index, but qualitatively, the same trends have emerged and any IG index that you're looking at. But, the ICE/BAML index had a duration of about five-and-a-half or six years, in the late nineties when the index was established.

Dan Belton:

It's about eight-and-a-quarter now. So, that's good for about a 35 or 40% increase in duration. Then, the second has been a very-often talked about topic and that's the deterioration in credit quality. Specifically, we're talking about the so-called Triple B problem. So, back in 1997, the index was about 27% triple Bs. It's 52% triple Bs now. It was 5% triple A's in 1997.

Dan Belton:

That's down to 1% now. Then, double A's made up 18% of the index in '97. That's down to 8% today. So, we've seen a massive deterioration and the credit quality of the index. We've also seen an extension of the duration. Now, both of those factors are not explicitly controlled for by the index. But, they should both lead to wider spreads, all else equal.

Dan Belton:

That's because, when you think about the duration, Treasury OAS curves are typically upward-sloping. So, all else equal, a three-year corporate bond will trade at a tighter spread than a 30-year corporate bond. But, the index today has more 30-year corporate bonds than it does three-year corporate bonds.

Dan Belton:

The same is obviously true for credit quality. A triple B corporate is going to trade, generally, at a wider spread than a single A corporate, which will trade at a wider spread than a double A. So, in order to sort of normalize for these qualities, we decomposed the index and then reconstructed it, using constant characteristics that were applicable in 1997. So, we used the credit composition of 1997, at the 27% of triple B's. We applied those weights to the IG index over time and saw what the resulting spread would be.

Dan Belton:

We did a similar thing for duration. We assumed that the index duration stayed at the five-and-a-half or six years that was applicable in 1997 and extrapolated that going forward. To see what spreads would be today if the index composition had been constant over the past 25 or so years.

Dan Belton:

The bottom line is that we found that, if the index had not deteriorated, both in a credit and duration sense, that spreads would be about 36 basis points lower today. In other words, this deterioration has been worth 36 basis points. Had it not occurred, we would see spreads more in the realm of about low fifties basis points, in the ICE/BAML index. Relative to the 87 basis points they sit at today.

Dan Krieter:

Okay. So, that's obviously a fairly large adjustment. Now, I'm curious, in that low-50 basis point on the index, how does that compare today versus other periods in history? Are we now way lower than it has been in the past? Are we at all-time lows? How does that stack up, historically?

Dan Belton:

Yeah, it's a good question, Dan. So, the next narrowest we see these adjusted spreads, came in early 2018. That's actually the last time that spreads, on a raw basis, were trading near current levels. So, the adjusted spread index that we've created traded about mid-60s in 2018. Then, just before COVID, the adjusted index got pretty close to that, too.

Dan Belton:

Touching just under 70 basis points. Then, before the crisis, we saw the index around mid-70s. So, today's spreads of low-50 basis points, call it 52, 53, that is the lowest that we have on record, by a good 13 or so basis points. With 2018 being the next closest to current levels.

Dan Krieter:

I think that's an extremely important takeaway, is, if you just look at the spread compensation investors are willing to accept for credit at this point, you can make an argument it's at all-time lows. So, when you look at credit from that perspective and then you think about the intersection in the summer months we talked about. Between deteriorating seasonality and more meaningful economic data, it just seems like, at least in the near term, there's not a lot of potential for spreads to keep falling.

Dan Krieter:

In fact, you said it earlier, Dan, I think there's a much higher chance to see spreads 15 wider than 15 narrower in the next three months. But, I also want to highlight another important takeaway from that analysis you did. You talk about spreads being at all-time lows, but you could also make an argument that that makes sense, given the central bank actions in the past 20 years. To put a stronger and stronger backstop behind credit, ultimately culminating in the 2020 cycle, with the Fed explicitly purchasing corporate securities for the first time.

Dan Krieter:

We've discussed this notion in previous episodes, just that credit spreads should be fundamentally narrower, given this Fed backstop. But, when you adjust the index, forward its compositional changes, you really see that start to play out a lot more dramatically. If you just look at absolute spreads on a chart going back 20 years, it looks like spreads sort of hit the same local lows. Around current levels, low-80s. At times reaching into the high-70s, going back pre-crisis. But, they've sort of bottomed out in that 75 to 80 basis point range, a number of times.

Dan Krieter:

But, when you make those adjustments, that floor that's on credit spreads actually starts to tilt and you can see a pretty clearly-observable downward trend in credit, really, since the beginning of the century. For that reason, I think that that trend will continue, as the backstop has strengthened. Particularly during the pandemic, we should get used to seeing spreads at historically low levels.

Dan Krieter:

For that reason, actually, I think there's considerable downward pressure, even at all-time lows, from current spread levels. I just don't think the environment is there to support it yet. If that's true, then we have to be looking at any spread widening that does come in the summer months as a buying opportunity.

Dan Krieter:

Especially with the expectation that buying opportunities will likely get less frequent and less substantial in future years. If we are truly headed for a transitory inflation environment with low yields and low spreads. A reach for yield being the sort of prevailing environment, like we saw following the financial crisis.

Dan Belton:

Yeah. Dan, it's worth pointing out that the Fed has tried to talk back this idea of some implicit backstop for credit. That's probably one of the reasons that they've decided to sell their corporate bond portfolio. But, we've talked about this in recent podcasts. That we don't think that, if a similar situation were to arise again in the future, that the Fed would hesitate to install a similar program to the corporate credit facilities.

Dan Krieter:

Yeah. I agree with that wholeheartedly. So, Dan, anything more to add on credit here, or should we move on to our third adjustment?

Dan Belton:

I think we can move on.

Dan Krieter:

Okay. Well, the third adjustment in our adjustments theme today is actually the technical adjustment that the Fed delivered to the short end last week. We've now had a week of data since then, to see how financial markets have reacted. Just wanted to talk a bit about that and lay out our expectations for the short end, going forward. So, we saw the technical adjustment, five basis points higher on IOER and RRP.

Dan Krieter:

As expected, we have seen SOFR print at five basis points since then. So, four basis point increase on SOFR. Similarly, Fed funds has traded for higher, from six basis points to 10 now. I guess it's important to note here that, as we expected in our episode last week, there has not only not been in decline in take up at the RRP. In fact, RRP volumes have gone up and are now approaching 800 billion. So, that really shouldn't come as a surprise.

Dan Krieter:

It's difficult to see why there was any expectation that the hike would drive voice and volume at the RRP. But, I think the most notable thing, at least for us, is that if you look at some of the more credit-sensitive rates, both BSBY and LIBOR, the increase at the short end, at least thus far, hasn't been as meaningful.

Dan Krieter:

Even today, after LIBOR's biggest jump of the year, a massive 1.3 basis point jump, we've only seen a total widening, for both BSBY and LIBOR of two-and-a-half. Maybe a little more than that, two-and-a-half basis points, since the Fed meeting. So, obviously, given the moves in SOFR, we've seen a bit of a narrowing between LIBOR/SOFR or BSBY/SOFR, which should, obviously, be a narrower for front end spreads and that's what we've seen.

Dan Krieter:

This is one of the reasons why we were favoring the steepener on the swap spread curve. It's difficult, at this point in time, to really like swap spreads going in either direction, higher or lower. Just given the very ample reserve environment we're in. The still-massive oversupply of cash, compared to collateral at the short end.

Dan Krieter:

Now, the question becomes, for me, now that we've seen the technical adjustment, what becomes the view now? So, let's break that down into a few individual questions that we can try to answer. So, first, do we expect there to be another technical adjustment, Dan? Or, do you think this will probably be it?

Dan Belton:

No, I don't think there will be another technical adjustment. I think it's possible that, over the next month or so, maybe the next five weeks leading up to the debt ceiling deadline, we continue to see some downward pressure on front end rates. But, I do think that the RRP presents a pretty effective floor on Fed funds. So, I don't expect to see Fed funds move from 10 currently, back down to six or five basis points in the near term.

Dan Krieter:

Yeah. I'm with you and you bring up the debt ceiling, which is unfortunately going to be a major driver of short end dynamics, I think, going forward. The Treasury cash balance is still pretty elevated. I mean, it jumps around a lot, day to day. So, it's difficult to say where we are, on any given day. It dipped below 600, I think and then it went back above 700. But, bottom lining it there, we still have a lot of Treasury cash that's going to be paid down in the course of the next month.

Dan Krieter:

Plus, ahead of the deadline, and then, if we don't get a timely resolution to the debt ceiling in August, which I think is a pretty high probability outcome, given the composition of Congress at the moment. We could see debt ceiling dynamics drag on for a few months, until, ultimately, Congress has to deliver a more durable solution. So, I just can't see any change to the oversupply of cash at the short end, in the near term. Can you?

Dan Belton:

No, I think it will have to wait until August, frankly. I don't see any catalyst for these massive trends to be reversed any time in the near term. Like you said, Treasury cash balance is likely to continue to come down. Then, bill supply shouldn't really turn significantly positive for the foreseeable future either.

Dan Krieter:

So, then, looking at the short end rate complex as a whole, you can really make two arguments. The one being you expect the adjustment at the front end to continue playing out in LIBOR/BSBY and you see those credit-sensitive benchmarks continue to back up. Reflecting the simply higher short end complex. Basically, the argument here being that BSBY and LIBOR have just lagged and they're ultimately going to fully move four or five basis points higher. Like SOFR and Fed funds has.

Dan Krieter:

Or, you could make the argument that those will stay narrow. That the technical adjustment just sort of mechanically force that narrowing to happen more quickly. But, the oversupply of cash to the short end is going to continue to result in downward pressure on LIBOR and BSBY. Then, ultimately, potentially further downward pressure, on at least short end swap spreads.

Dan Krieter:

So, for me, and I hate to bring it back up again, but the driving factor is going to be the SLR. We're going to get an SLR ruling at some point in the near future. I'm a little surprised it's taken this long, but it's going to come. Once you get that SLR certainty, it's going to impact the short rate complex in a few important ways.

Dan Krieter:

The most straight-forward, and the one we've talked about most, is that it should just give a green light to banks holding treasuries in the belly of the curve, where their holdings are most natural. So, you could see some widening of belly spreads there. But, I want to talk about another factor that is potentially not as often discussed.

Dan Krieter:

That's the impact of SLR on LIBOR. Because, as we've seen in the past few months, commercial paper outstanding has reached post-crisis highs. That's been driven almost entirely by financials. I think non-financial commercial paper is flat, or maybe even lower. It's been a massive increase in financial commercial paper. Then, when you think about it from an SLR standpoint, that makes sense.

Dan Belton:

Yeah. With banks sort of waiting out this uncertainty on SLR, the way to fund yourself in the short term that makes most sense, is to do it in the CP market. Because, as you've mentioned, those rates are very low. You look at LIBOR or look at BSBY and also, that paper matures within several months. So, there's not necessarily going to be a refinancing needed to be done once this SLR certainty pops up.

Dan Krieter:

Yeah. What you're saying is, commercial paper gives you more flexibility, when you don't know exactly what's going to happen from an SLR standpoint. I agree with that completely. So, if you think about, once we get the SLR rule from the Fed, commercial paper outstanding would then, most likely, fall. Potentially fall precipitously. Well, then, if you have a big declining commercial paper outstanding, all that money that's currently invested there is going to be chasing a lower supply of unsecured funding products.

Dan Krieter:

In that lens, you could see LIBOR and BSBY then continue to narrow and, potentially, even push spot, LIBOR or Fed funds to zero basis points. Or, it wouldn't even shock me to see negative in the spot market. So, when you look at it from that perspective, it's really hard to like wider short end swap spreads at the moment. Just given the debt ceiling, our expectation for cash to remain high and the potential impact that SLR could have on the supply of commercial paper.

Dan Krieter:

So, even though we've seen the swap spread [inaudible 00:18:54] perform, I think we're five basis points in on the money since we implemented that view. It's still the view that I prefer. I still think that's the place to be on swap spreads, at least until we get a final SLR rule and there's a bit more clarity. We can reassess what's going to happen, potentially ahead of a move wider across the curve later in the year. But, I just don't see it for now.

Dan Belton:

Yeah, Dan. I completely agree with that. Before we wrap up, just a quick note. Given our neutral view on credit, I think technicals are likely to play an outsized role in the market over the next few weeks. Before we get more uncertainty on the inflation picture, later on this year. So, the technical outlook for the second half of the year, and specifically the third quarter is something that we're going to be focused on. Both in our written weekly on Friday, and then next week's episode of the podcast.

Dan Krieter:

So, please look out for that and we'll be back next week.

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, at @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 2:

This podcast has been prepared with the assistance that 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. Not a research report that reflects the views of disinterested research analysts.

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:

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

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