On Friday, in “Credit Disagrees With U.S. Stocks (Again): Who’s Right?“, I highlighted a new Goldman piece that documents the underperformance of IG (CDX in this case) versus equities.
At the beginning of that short post, I referred folks back to a discussion of the “hierarchy of vulnerability” as delineated by Deutsche Bank’s Aleksandar Kocic earlier this year following the February market tumult:
There is a sense in which credit is perhaps more vulnerable than stocks as central banks continue to rollback accommodation. Clearly, tapering, balance sheet rolloff and rate hikes have implications in the credit space, but more to the point, HY has been effectively insulated from idiosyncratic risk by the global hunt for yield. Investors have been chased down the quality ladder and that mad scramble has left everything but the dodgiest of credits priced to perfection.
On the IG side, there’s a duration story at play and as Deutsche Bank’s Aleksandar Kocic detailed in a series of notes earlier this year (see here for some excerpts), “as robustness of the HY had been accepted, IG, at the same time, has become associated with macro-systemic risk .”
In the Goldman piece, the bank’s John Marshall, Katherine Fogertey and Rocky Fishman make the connection to Europe, noting that while European equities have similarly lagged credit when it comes to pricing risk from the Italian situation, it’s a magnitude story as opposed to the U.S. where it’s a question of who is right about risk-on vs. risk-off. That is, at least in Europe equities are sending the same signal (i.e., selling off), if not to the same extent as credit:
Later on Friday, I also highlighted some commentary from BofAML, who notes that similar to the narrative stateside, where duration risk has made IG in some respects more vulnerable than HY from a macro-systemic perspective, in Europe the Xover/Main ratio has fallen to the lowest in nearly a year (across the pond this is perhaps a reflection of the extent to which, in synthetics, IG is more exposed to Italy than HY):
Well in his latest note, the above-mentioned Kocic takes up this issue again, reiterating his points from earlier this year on the way to noting that credit stands somewhat alone in terms of signaling broader contagion from Europe.
“During the last episode, IG had widened more than usual relative to HY,” Kocic writes, referencing risk off episodes from earlier this year, before adding that “while this is atypical in general, the dispersion is consistent with the recent stylized facts whereby IG has been behaving like duration and linked to systemic risk while HY, which has considerably lower duration (and has in the last years had low default history) has been straddled between duration and equity, leaning more towards the later.”
He contrasts that with curve risk premium and FX vol., which have fallen back to levels seen prior to 2018. One way to illustrate the bifurcation is simply to plot FX vol. versus IG:
As Kocic goes on to note, as long as the situation in Italy doesn’t spiral out of control (i.e., become systemic), “one is unlikely to see significant turbulence in US rates or in FX”.
That said, he does caution that the uncertainty inherent in the situation (it’s not exactly like Five Star and League are going come to some kind of grand consensus with Brussels overnight), is “likely to provide a lower bound on gamma”.
Finally, Kocic delivers an update on the extent to which the mode of the curve is being normalized where normalization entails bringing vol. back to the front end as described in previous notes and as summarized and documented most recently here in “Transparency, Trust And The ‘Fed In Wonderland’”.
“Current vol differential between 10Y and 2y gamma is near the lowest post-2008 levels,” Kocic writes, before saying there’s still a ways to go yet (see chart below). As usual, a scenario where any of the myriad risk narratives (e.g., Italy, EM turmoil) triggers a full-blown risk-off event (and thus a repricing of the Fed) could accelerate the process:
The ongoing process of curve normalization, which we identified with migration of vol to the front end of the curve and restoration of directionality of the slope, is likely to continue, but possibly at slower pace.
We are on the way to normalization, but not there yet. Deepening of the crisis could accelerate this though. Such outcome could interrupt Fed trajectory causing it to either skip some hikes, or if the things get really bad, push us closer towards a recession and force the market to price in future rate cuts and bull steepen the curve
Circling back, the question is this: “transient or persistent?”
As Kocic observes, “a consensus on that issue is still not clearly legible from the market pricing.”
One thing’s for sure, there’s some spillover risk being priced into financial spreads across the pond: