One of the inevitable (indeed, intentional) consequences of QE and accommodative monetary policy more generally was that investors were driven out the risk curve and down the quality ladder in search of yield.
This is such a familiar refrain that it wouldn’t even bear mentioning at this point were it not for the fact that it’s now reversing – with entirely predictable consequences.
Assets of all stripes have performed poorly in 2018 and the proximate cause is the withdrawal (however gradual) of accommodation.
As yields on riskless USD “cash” rise, money is sucked out of risk and in the process, the dynamic that left everything priced to perfection fades. Suddenly, idiosyncratic, company- and sector-specific risk gets priced back in. Spreads widen, volatility rises and legions of investors who have never known what price discovery looks like are left wondering what happened.
Read more on why 2018 is different
The read through from the above for credit markets is clear: dispersion will rise as the insatiable appetite for yield no longer serves to paper over the risks associated with individual credits and sectors. This is common sense and BofAML’s Ioannis Angelakis offers one of the more poignant illustrations of the dynamic we’ve seen to date in his year-ahead European derivatives outlook.
“The comeback of idiosyncratic risk was the biggest theme this year”, he writes, adding that “with spreads at the tights earlier this year, the danger was that idiosyncratic risk could take away lot of P&L – and it did.”
This is an especially sensitive issue for European credit. CSPP (i.e., the ECB bid) was a powerful force and it goes without saying (or at least it should), that when a price-insensitive buyer armed with a printing press is loading up on IG, other investors are driven into high yield.
Now, € credit faces an especially challenging backdrop that finds the CSPP bid on the verge of ceasing (as APP is wound down from December) while the appeal of USD cash lures investors from afar (FX hedging costs notwithstanding). Here’s a visual that shows 3M LIBOR rising above the yield on the Bloomberg Barclays Global Aggregate index (i.e., global fixed income) for the first time since the crisis.
“Even though fundamentals are still supportive, the lack of flow amid rising yield differentials between Europe and US are amplifying idiosyncratic risks”, the above-mentioned Angelakis continues, in the same note, before driving the point home by reiterating that “if QE ‘hides’ the weaknesses of companies, when the QE tide goes out, the weakest issuers may see support for their bonds disappear [as] ‘Alpha’ is finally back as dispersion is rising, and no one wants to catch a falling knife.”
Consider that, and then consider the following set of visuals from BofAML:
That is pretty remarkable. The left pane shows that most of the paper issued this year is now trading below par. The middle pane shows how the previously indiscriminate bid for junk led to an across-the-board rally. The right pane shows that indiscriminate bid slamming into reverse as falling-knife-catching went out of style.
Needless to say, poor liquidity isn’t going to help in the new environment and because it would be impossible to sum this up any better, we’ll leave you with one more quote from Angelakis (although you can hopefully surmise this, “the largest ETF buyer” refers to Mario Draghi)…
In a non-CSPP world, the largest ETF buyer will stop buying more bonds. We have reached that point where single-name analysis is key as the carry trade facilitated by the ECB’s CSPP is coming to an end. Our mantra has always been: fundamentals will matter again as the largest ‘ETF manager’ steps out of the market.