‘Rates < HY < IG < Equity': Hierarchy Of Vulnerability Revisited

Last Friday, Deutsche Bank’s Aleksandar Kocic laid out what he calls the “Hierarchy Of Vulnerability” for markets “at the intersection of politics and policy.”

Over the past several weeks, ongoing turmoil at the White House has collided with and exacerbated geopolitical and economic policy uncertainty, with the former manifesting itself in the decision to replace H.R. McMaster with notorious war hawk John Bolton and the latter represented by the apparent victory of the protectionist contingent embodied in Peter Navarro.

That’s set against a Fed that wants to normalize policy and take control of curve dynamics along the path to that normalization. This is a delicate task and it’s being undertaken with a non-economist, rookie Fed Chair at the helm.

Kocic’s take is that equities are on the front lines in terms of where volatility is likely to show up. “What is the hierarchy of vulnerability in this context – which market sectors are going to be more vulnerable than the others?”, Kocic asked.

Again, the short answer is: stocks. You’ve probably noticed that the long end seems to have benefited from a safe haven bid of late and as Kocic noted on Friday, “based on last week’s finale, rising geopolitical risk and trade tariffs [may] provide support for bonds which, when coupled with a more hawkish Fed, could add more flattening bias.”

Well Treasurys rallied hard on Tuesday amid the tech chaos with 10Y yields diving 8bps and on Wednesday morning, yields broke through the 50-DMA for the first time since December.

As Bloomberg’s Brian Chappatta writes on Wednesday:

Treasuries traders are watching for any sign that this year could be déjà vu from 2017, when expectations for higher yields were dashed by March. Last year, it was disappointment over inflation misses and the Trump administration’s inability to make progress on its fiscal agenda.

Now it might just be tech stocks.

Yes, it “just might be.” And when considered with the idea that, as noted above, last week’s action suggested equities are likely to be hit first in the event (geo)political tension escalates and/or the trade war threat becomes even more real that it already is, it would appear that Kocic’s hierarchy of vulnerability makes a lot of sense as a framework. Recall one more passage from last week’s note:

It argues in favor of outperformance of equity vol over credit, with a possibility that further escalation of political risk taking rates deeper into gamma bearish territory. We have already seen the onset of this pattern of repricing. The two figures show comparison of credit, rates and equity volatilities.

Ok, so that brings us to a note from Kocic that was apparently sent to clients on Tuesday (as far as I can tell) and in it, he fleshes this out more on the way to making a couple of points about the extent to which IG has actually become more “risky” than HY. To wit:

While Implied/Realized ratios have been trading on top of each other, IG skew has been trading richer to its HY counterpart since the end of 2016, while IG vol continues to outperform HY vol pushing their ratio to new highs.

This seemingly counterintuitive result (IG seems to be more risky than HY) has a distinct “path-dependent” flavor. In the last several years, there has not been any significant defaults in the HY. With a long period of QE, most of the issues associated with HY have been perceived as the problem of the past. As robustness of the HY had been accepted, IG, at the same time, has become associated with macro-systemic risk. Gradually, HY vol became the funding leg for multitude of cross-asset trades, while IG compression towards all time low made it vulnerable in a broader context. As a consequence, the spread between IG and HY vol continued to widen.

You’ll note that’s broadly consistent with the notion that global QE has for years been propping up the high yield market. Recall the following excerpts from “Rise And Fall Of The ‘Zombies’” in which we cited a BofAML note on the way to underscoring the idea that QE has distorted the HY market beyond recognition:

Of course you can’t expect the investment community to “show discipline” in an environment where yield is an endangered species. The relentless chase down the quality ladder catalyzed by central banks dumping $15 trillion-ish at the top of that same ladder ensures that everything gets priced to perfection on the way down, with the sole exception of companies that are on the verge of default. Here’s schematic from Citi:

This raises questions about what happens when the accommodation that creates that dynamic fades or, more to the point, when central banks start to wind down their balance sheets. What happens to the zombies (so to speak)?

This is a pressing issue in Europe as the ECB tapers APP. So far, Draghi has demonstrated a propensity to lean on PSPP when it comes to shouldering the taper burden while keeping the CSPP bid largely in play. The Steinhoff debacle raises still more questions — that is, what happens if the ECB actually becomes an active seller of fallen angels while it simultaneously stops actively buying IG? Does that then set the stage for some kind of acute domino effect that causes spreads to blow out? More on that here and here.

Well in a new note, BofAML revisits the zombie problem (see here for some highlights from their original exposition) and the following chart is extremely telling:

So obviously that’s the 6-month change in the Fed’s balance sheet against HY energy defaults and as BofAML notes, “as the rate of growth in the Fed’s balance sheet slowed to zero in March 2015, US high-yield energy defaults began to rise.”

Meanwhile, as we saw when LQD suffered massive outflows last month as rate rise and duration risk spooked investors, the IG story has to a certain extent become, as Kocic put it on Tuesday, “associated with macro-systemic risk” (think: the tail risk associated with bond trade unwind being realized).

And so, here again is the “current hierarchy of vol ratios” from Kocic, which “outlines the market’s perception of risk across different sectors: Rates < HY < IG < Equity“:

(Deutsche Bank)