Just in case you were wondering, we’re not going to let the whole “HY is in a bubble” thing go.
Because for the thousandth time, it’s hard to imagine how spreads can possibly compress any further, especially considering i) where oil was trading the last time spreads were as tight as they are now, and ii) the ongoing drag from the train wreck in brick and mortar.
Of course lurking in the background is the same worry that hangs over all risk assets – namely that the disconnect between political/policy uncertainty and asset prices has almost never been more evident.
Underscoring that latter point is BofAML, who on Thursday notes that the “since 1984, there have been just 3 times where the Policy Uncertainty index was above its long term average while HY spreads were below their long term mean for at least 6 consecutive months: From 1985 to 1987, early 2011 and today.”
Note below the Policy Uncertainty index maintained by Baker, Bloom & Davis and the corresponding correlation with spreads. Since 1984, there have been just 3 times where the index was above its long term average while spreads were below their long term mean for at least 6 consecutive months: From 1985 to 1987, early 2011 and today. From 1985 to 1987 spreads were at a similar level to now, and although on average remained below their historical trend, they widened from 342bp to as much as 519bp during the period. In 2011, spreads remained relatively tight and flat, though we would argue US quantitative easing was a main driver for their lack of movement. Today’s period has represented a unique time where policy uncertainty is elevated but spreads have continued to grind lower: we think this is unsustainable when considering a central bank inclined to tighten monetary policy rather than loosen.
Given the ongoing controversies in Washington – and the potential impact they may have on achieving the President’s agenda – coupled with the risks from the late stages of this economic cycle, history would suggest markets are likely to perform poorly.