If This Is The Big One, ‘You’re Going To Have To See It Here Too’…

The credit market has largely ignored the sovereign yield back-up. If the great crack-up is here, you’re going to need to see it in credit, too. Stay tuned

That’s from former FX trader Richard Breslow and it’s an important point.

For quite some time, analysts and the commentators who know what they’re talking about have observed that if you had to pick one asset class that’s been the most Teflon in a universe of seemingly bulletproof assets, credit would be a good candidate.

Both IG and HY have shrugged off virtually everything that’s been thrown at them. The ranges have been so narrow that if you look at history, 2017 has been among the most “boring” years on record.

If you want to see just how resilient credit has been, look no further than € IG spreads, which have ground steadily tighter despite multiple political land mines or, if it’s HY you’re interested in, have a look at USD HY spreads and the extent to which they’ve held up (or “held down,” as it were) in the face of oil prices which have, at various times, plunged.

Even HY Energy is just now starting to widen, having dodged previous “oil spills” without so much as a peep. Indeed, perhaps the best visual of all when it comes to illustrating credit’s resilience is the following chart which shows that HY Energy has dramatically outperformed energy equity in the US YTD:

(Goldman)

Getting back to the Breslow quote excerpted here at the outset, it’s definitely worth noting that credit hasn’t flinched over the past couple of weeks despite the dramatic rates selloff.

Here’s Goldman:

The sharp move higher in rates over the past two weeks has been so far well digested in both the USD and EUR corporate bond markets (Exhibits 1 and 2). In Europe, the 33bp back-up in the 10-year bund yield since their local trough on June 22 has coincided with tightening of 8bp in IG spreads, and modest widening of 5bp in HY. In the US, where the rates move has been somewhat more contained, USD IG and HY spreads have tightened by 5bp and 9bp respectively, over the same period.

The key driver of the recent rates move has been in part due to remarks by ECB President Draghi coupled with slightly stronger-than-expected inflation prints in Germany. Comments by ECB Board Member, Peter Praet, that deflation risks have ‘virtually disappeared’ have added to the pressure. Should the recent move higher in rates extend, we expect spreads will prove resilient, i.e.: the negative spread/rates correlation shown in Exhibits 1 and 2 will likely persist.

Yes, the “negative spread/rates correlation will likely persist.”

But there’s something ironic about that. Namely, the reason rates are rising is because the ECB (and others) are leaning hawkish or, more poignantly, talking about taking their foot off the accommodative policy accelerator. And yet the very reason why credit has remained resilient in the face of the mini-tantrum in rates is because of ECB corporate bond buying. Here’s BofAML:

With CSPP having been less impacted by the first tapering phase (down to €60bn per month, from €80bn previously) as shown in chart 5, we find that the ECB is increasingly reliant on primary market to add more paper in the QE program.

CSPP remains a key contributor to European credit market stability. In chart 6, we present the trends exhibited in the IG corporate bond market in terms of supply and the percentage of the assets that the ECB is accumulating under the CSPP via the primary market. It is clear that the ECB is using the corporate bond primary market to add QE assets “quickly” under the program.

Actually, in months where the ECB is relying more on primary corporate bond market to add paper, the ECB is also favouring CSPP over PSPP (chart 7). This was more apparent in May and June, as the ECB has allocated more resources in CSPP, which also was the highest since September last year (a month of typically high issuance levels and thus high pace of purchases for the CSPP program).

In our view, this should support credit spreads in months of high supply, but equally support strong technicals on the secondary market as in months of low supply, the ECB will resort to secondary market to keep buying, and thus possibly will keep “squeezing” spreads tighter.

Right. So rates are rising because the ECB is talking about rolling back stimulus and yet credit is resilient to that uptick in rates precisely because of that same ECB stimulus.

“Do as we say in rates and do as we do in credit” – or something.