Just two months ago, the chief concern for European credit investors was “bubbles” (i.e., “too much liquidity”) and it wasn’t difficult to discern why. After all, CSPP has created all manner of distortions across € credit which, until recently anyway, was priced for perfection.
The ECB’s corporate bond buying binge has helped € credit spreads remain tight amid various manifestations of the upsurge in populist sentiment across the pond, but the program is rife with moral hazard. Draghi, for instance, got a rare helping of humble pie late last year when the ECB’s “fallen angel” risk was realized during the Steinhoff debacle.
One of the issues the Steinhoff episode raised is the prospect that once the ECB’s footprint in the market begins to dissipate, price discovery will return with a vengeance and spreads will widen to reflect sectoral fundamentals and issuer-specific risk. This is compounded by the global shift towards less accommodative monetary policy.
The following visual is from the latest edition of BofAML’s European credit investor survey and it shows that generally speaking, both IG and HY investors believe spreads will widen out when CSPP is wound down.
“The twin effects of Quantitative Tightening by the Fed and the withdrawal of Quantitative Easing by the ECB have left European credit amid a bear market in technicals”, BofAML’s Barnaby Martin and Ioannis Angelakis wrote late last month, adding that “the obvious consequences of this are soggy markets (less ‘buy the dip’ conditioning by investors), higher new issue premiums, and less spread compression as ‘crowding’ into higher-beta parts of the market fades.”
Martin and Angelakis equate that with fragility and when you combine the less favorable technical backdrop with the summer lull, you end up with a market where the primary concern is now vanishing liquidity. Here’s the above-mentioned Barnaby Martin, editorializing around the results of the bank’s latest European credit investor survey (the same poll mentioned above):
Credit markets are on course for a healthy summer of performance. Yet, investors’ biggest worry has pivoted from “Bubbles in Credit” to “Liquidity Vanishing”, the first time in 3yrs that this has emerged as the chief concern. Chart 2 shows the history of credit investors’ greatest concerns. In the space of two months, the fear factor has swung from Bubbles in Credit (i.e. too much liquidity) to Liquidity Vanishing.
Perhaps it just reflects the usual holiday slowdown in trading. However, one clear characteristic of the summer rally is how big – and random – spread dispersion has been. And coupled with the growing number of “corrections” being observed across financial markets in 2018, portfolios remain a challenge for investors to risk manage. Hence, it’s not trade wars or an equity market correction that look to be keeping credit investors up at night, the concern is a more pervasive rush for the exit at some point in the future.
What could ameliorate that situation? Well, amusingly, a more hawkish Mario Draghi. Or at least according to some survey respondents.
The results there underscore the uncertainty around what the end of ECB corporate bond purchases will mean for European credit markets. 32% of respondents to BofAML’s poll suggested that more attractive yields in IG are what’s necessary to bring retail investors back. But 21% think it’s the opposite; that is, retail money would be more likely to get excited again if Draghi were to tip more QE, thus allowing everyone to keep frontrunning the assumed credit rally.
“Paradoxically, credit investors now yearn for a faster normalization from Draghi, to help restore credit inflows, and counter the growing signs of ‘fragility’ in European corporate bond markets”, Martin writes.
As ever, this should be viewed in the context of the broader debate about market fragility and liquidity provision. 2018 has seen myriad examples of “fragility events”, with the VIX spike in February being the most high profile case. A close second is the turmoil that unfolded in the Italian government bond market on May 29, when 2-year yields spiked the most in history amid concerns that fresh elections were in the cards.
Just to kind of close the loop here, one of the amusing side effects of that episode was that between the selloff in BTPs and the ongoing support for Italian corporate credit emanating from CSPP (or from people frontrunning CSPP), 90% of Italian credit ended up trading tight to similar maturity Italian government debt.