“Has The Whole World Gone Crazy?!” Part Deux

Ok, so this…

… was exceedingly amusing and pretty interesting/important. I encourage you to read it if you haven’t.

The overarching point was simple: what exactly is it that sovereign spreads know that € credit quite clearly doesn’t?

And relatedly, if iTraxx Main is moving with OAT-bund spreads, doesn’t that suggest that credit actually does know what rates know but just isn’t expressing it?

Well I’ve gotta tell you, Citi has been all over this subject and they’re out on Friday with another great piece.

citi has been all over this with good reason. good for them pic.twitter.com/TBkWsM1zM3

— Heisenberg Report (@heisenbergrpt) February 24, 2017

As you think about the blow out in OAT-Schatz and OAT-bunds, consider the following.

Via Citi

iTraxx Main is trading inside of 2yr swap spreads for the first time since 2008.

Especially given how it’s tracked the move wider in French sovereign risk premia, we see the Schatz rally and consequent rise in swap spreads as reflecting rising perceptions of political risk, rather than simply being attributable to QE.

At the same time, credit has been almost remarkably sanguine: though this week has seen signs of switches out of France and the periphery into German and Scandi credits, IG spreads on the whole are at their tightest since April 2015.

It’s understandable that credit has been able to ignore a measured rise in sovereign risk premia. Yet we question how long this disparity can be sustained, and we see little value in spreads at these levels.

With swap spreads still liable to rise from here, even beyond the implications for risk appetite, keeping track of these remains vital if investors want to avoid being dragged through their hedges backwards.

As far as milestones go, this week has hardly attracted much fanfare. But, for the first time since 2008, 2yr swap spreads have moved wider than iTraxx Main (Figure 1 and Figure 2 ). Of course, the two aren’t directly comparable. One measures the gap between a 2yr swap and an equivalent maturity Schatz yield while the other isolates 5yr credit risk on a basket of European corporates. And whereas in 2008, the massive safe haven bid came as asset prices everywhere were plunging, this time around the squeeze in short dated govies has been driven, at least until recently, by PSPP purchases, exacerbated by the recent decision to buy bonds with yields below the deposit rate.

Yet, as Figure 3 shows, and as our colleagues in rates have noted, it would be mistaken to attribute the latest leg of the Schatz rally, and consequent rise in swap spreads, entirely to QE. Instead, we’d argue that the surge in safe haven demand is very much associated with rising perceptions of political, and particularly France, risk, especially given that it’s come against a backdrop of strong economic data. And, indeed, it’s hardly surprising that swap and credit spreads have tended to track each other over time. Put simply, the heightened risk aversion that has historically driven the haven bid for Schatz has also tended to drive credit spreads wider. But this time around, despite the evident rise in safe haven demand in rates space, credit has barely budged.