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Fed vs Credit: crisis averted?


Summary • The Fed’s backstop helped bring down credit spreads – both investment grade and high yield • Banks appear positioned to make it through the Corona Crash according to their CDS spreads • Small US energy companies may need to lean on Federal Reserve support should oil stay low

Junk bonds, those rated BB or lower, surged earlier this month as the US Federal Reserve announced they would be buying high yield ETFs for the first time in history. The announcement came on April 9, less than three weeks following the equity market low on March 23. On the news, speculative grade bond ETFs rose sharply – HYG, JNK & USHY each gained more than 6%. Not surprsingly, the ETFs also experienced major inflows. HYG may be on pace for its biggest capital inflow month in years.

After the Federal Reserve announced their buy program, credit spreads narrowed considerably, but that was also the trend since the March low. The S&P 500 had already risen 23% and US high yield credit funds were up 13%. The S&P 500 has drifted higher since while junk bonds have consolidated their gains.

Nevertheless, there is still some concern among market participants in the bond space. Currently, the US Investment Grade Credit Spread, picture below, is about 2.3%. That is the same level as the peak in early 2016, a time in which US corporate earnings were particularly weak and recession fears were significant ahead of the presidential election.

These charts are from the latest Global Cross Asset Market Monitor.

Jumping further out on the risk spectrum, the US High Yield Credit Spread is near 700 basis points. That level is slightly below the peaks from the 2011 European deb crisis period (which coincided with the S&P downgrading the US credit rating). 7% is just under the the early 2016 market turmoil spike – a time when oil prices collapsed to under $30 per barrel.

The Corona Crash has hit some sectors particularly hard. Energy is one of those arenas. While the iShares High Yield ETF (HYG) is composed mainly of communications & consumer companies, US oil & gas exploration and production firms depend on risky credit for operations. Perhaps the Fed saw this space as a good target to help stabilize liquidity concerns considering oil prices have fallen from $65 in January to under $20 per barrel.

While IG & HY spreads have retracted in recent weeks, so too has credit default swap pricing among the big Wall Street banks. Investors seem less concerned about the liquidity position of major financial institutions versus past periods of economic difficulty. Every recession is different. 5-year CDS spreads spiked to about 150-200 basis points at the height of fear in March, but are now closer to the early 2020 lows, and well beneath the early 2016 peak.

So the banks’ ability to pay back debt in the next 5 years is not a major risk according to the market. Obviously anything can happen, but there are other things to worry about. This economic crisis is focused on small businesses and near-term cash flow needs. Time will tell what bullets the Fed uses next and how Congress enacts fiscal policy to further support small business.

Here’s the point – comparison to 2008 may not be appropriate. Every recession has its own quirks, and so too does this crash. And it is a crash when looking at GDP loss over just a few months. Pundits are tossing around “U-shaped”, “V-shaped”, “W-shaped” even “swoosh” to describe this recession. Nobody really knows, but we can monitor certain indicators to gauge market stress.

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Topdown Thomas Thoughts: Another thing I would add is how this is yet another angle on the "stimulus vs social distancing" theme. You can see in the chart below how there is a bit of a breakdown in the relationship here between credit spreads and the economic cycle indicator (I don't think I ever foresaw the possibility for this type of event when designing that indicator!!). Some might argue this basically represents the Fed driving a wedge between economic fundamentals and the market, and maybe they're right. But others might argue the Fed IS a fundamental. Anyway, I highlighted to clients back in March how credit spreads had moved into the "cheap" valuation space, and sentiment had switched to extreme pessimism >> two poignant contrarian signals. I couldn't bring myself to make an outright bullish call in credit, but at least moved to "not bearish". From here, while I don't hate credit, I do find it hard to get excited about and can see better risk/reward elsewhere.

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