You know, I was going to leave the central banks distorting markets theme alone for the rest of the day. I really was.
After all, I’ve already talked about it on Saturday – twice.
Once in “Goldman Presents: ‘FOMC Alpha’ Or, How To Trade The Fed,” and then again in “Last Week, We Witnessed “The Mark Of A True Magician.”
But as I was thumbing (or I guess “scrolling” is more accurate, since no one remembers what it’s like to read something printed in real ink on real paper and anyone born after the turn of the century doesn’t even know that physical books were once real things) through another Deutsche Bank note, I ran across some good commentary that kind of builds on the point Citi’s Hans Lorenzen made about the muted reaction in credit to the political turmoil in the UK.
Recall this excerpt from the Citi note cited in the second post linked above:
It’s a kind of magic – From the surprisingly muted reaction to extreme UK political uncertainty to the vanishing hope of any hawkishness from Draghi, central bank action is allowing markets to maintain their remarkable ability to ignore almost any amount of political or economic uncertainty
That of course echoes what we noted on Friday in “It’s Simple: ‘Buy What They Buy’” in which we highlighted a BofAML piece that contained the following rather succinct advice for credit investors:
Well, that’s all about IG, but the same applies to HY because invariably, the never-ending experiment in central bank balance sheet expansion just serves to drive investors down the quality ladder in search of some semblance of yield.
So with that in mind, consider the following from Deutsche Bank and do note the hilarious characterization of QE as a “dead end-end policy.”
Via Deutsche Bank
Credit markets remained stable over the past two weeks, with spreads closing roughly unchanged for the period. HY OAS is currently at 382bps, within its relatively narrow 370-390bp range established over the past few months.
HY funds have registered a modest pickup in inflows during this period, averaging roughly $300mn/day. This is in contrast to virtually zero net flows for the global HY fund category YTD, and $7bn in withdrawals for the US HY segment.
Dealers made little progress in rebuilding their HY inventories, which currently amount to $3bn, down from their recent peak of $7.4bn in March and a $5.0bn average since 2013.
So what are we thinking here? Most models we employ to judge credit suggest that valuations are somewhat expensive across the board, which should not come as a surprise to most of our readers. They also point towards loans as being the most expensive segment in credit, followed by short duration HY, then long HY, and closing out with IG as being less expensive than others.
And while credit valuations are somewhat tight here, in our opinion, they could get even tighter, before they normalize. This view rests primarily on our understanding of where we are in the credit cycle coupled with extremely low volatility levels across multiple assets, and primarily in credit itself and equities.
Low volatility, in turn, is a byproduct of continued support from global central banks. And they continue to do their part in prolonging this arguably overextended credit cycle. The latest piece of news came from the ECB on Thursday, which boiled down to a guidance of no more policy loosening. So this will take a while. The BOJ is only beginning to contemplate how to adjust its messaging, so it is arguably even further behind the curve towards exiting the dead-end policies.
And the Fed, while having made more progress than others, continues to move in baby steps following its damaging experience of late 2015. All in all, these developments suggest that excess liquidity conditions driving global investors towards US credit will probably remain in place for a number of months to come. One volatile variable that could potentially upset this equilibrium is oil, which has experienced a 3.5x sigma drop on Wednesday, and is now 15% below its recent peak level registered in Feb.
As we discussed previously, we continue to think this development is directly problematic to energy credit valuations here, as those remain stubbornly tight despite substantial weakness in energy equities. Energy HY OAS has only given back its YTD tightening in the last two days, while energy equities are down 14% since Jan 1.