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ChartBrief 197 - TED, Fed, Credit

March 21, 2018

There's a lot going on in this space at the moment, so I thought it would be good to weigh in on the topics of the TED spread, the Fed, and credit conditions/credit markets.  Those with bearish inclinations have jumped and salivated at the prospects of spread widening, funding cost blowouts, and the lies of LIBOR.  But in this article I aim to take a sober assessment of where I see things based on our indicator set and add a bit of perspective with some slightly longer term charts.

 

If the years since the financial crisis have taught us anything it is to be skeptical of fear-mongers and perma-bears. Indeed, actual investors need to be wary of jumping at shadows when history shows us that in the long run it's the optimists who inherit the investing earth.  But that's not to say we shouldn't be monitoring risks and keeping tabs on changing market conditions (+look to be constantly developing new analytical technology), and of course falling back on a sound risk management process.

 

And, while I continue to run with the thesis (based on the evidence I see at the moment) that the global economic upturn remains intact, and that the US economy is running at a solid pace... conditions are changing.  Not to wear out my message, but the 3 key themes of: higher valuations across asset classes, a maturing business cycle, and turning global monetary policy tides mean 2018 and beyond brings with it changing and more challenging risk/return dynamics across asset classes.

 

Taking the particular lens on the Fed/US monetary policy, and US credit market conditions, it's clear we are in the later innings.  As monetary policy progressively tightens, the burden of proof to hold US HY credit at such extremely tight spreads also rises.  And the importance of keeping close tabs on this corner of the market should not be lost, because there are some early warning signs.  But until we see more considerable policy tightening and a turn in economic conditions it's still mild concern rather than a case of high conviction net-short.

 

The main takeaways from the Ted/Fed/Credit charts are:

-Putting the TED spread in longer term perspective shows even with the latest movement it's only around long term average levels.

-Historically, Fed policy tightening ultimately leads to a tightening of credit conditions.

-There are some early signs of issues in the corporate CDS markets, and it remains to be seen whether this is idiosyncratic vs systemic.

-The burden of proof to own credit at such tight spreads is rising.

 

 

1. TED Spread: First up on the charts is a look at the infamous TED Spread. This indicator still gets a lot of attention because of the way it trended up and ultimately blew-out to record levels in the years and months preceding the financial crisis.  Much has changed in the nature of the global financial system since then, including regulations etc.  But even factoring in those changes, it's important to keep the latest action in this indicator in perspective.  It rose throughout 2016 - which was well *after* the risk-off episode earlier that year and ended up being a complete false alarm.  And even the latest reading is only just approaching the long term average.

 

2. Fed Funds Rate vs Credit Spreads: But that's not to say that there's nothing going on out there.  Monetary policy is on a tightening path in America, and to briefly take stock, as of today's FOMC decision we have now seen fully 6 rate hikes (totaling 150bps) and quantitative tightening is underway, with just over a $40 billion reduction in the Fed's holdings of US treasuries since October.  History tells us (perhaps with the exception, or delayed reaction, of the mid-2000's) that when you tighten monetary policy you ultimately see a tightening in credit conditions.

 

3. Corporate CDS Pressure Index: And one potential early earning sign of a tightening of credit conditions can be seen in our Corporate CDS Pressure Index. This index surveys the action in CDS sector indexes and overweights the impact of spread widening in particular sectors.  The main culprits have been telecoms, personal household, healthcare, and retail.  It remains to be seen whether this reflects idiosyncratic or temporary factors vs a more systemic elevation in credit stress - which is something that would naturally flow through into higher credit spreads more broadly.  We continue to run a bearish medium term bias on high yield credit, but for now a lack of catalysts gives pause before going outright short, particularly given the still strong domestic and global economic currents.

 

 

 

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