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credit high yield investment grade Markets

As Greed Returns, Remember: ‘Strong Rallies Should Lead To Less, Not More Optimism’

"...sometimes you are compensated for this skewed perception and other times you are not."

Now that it looks just as likely as not that the Fed’s tightening cycle is over, investors theoretically have the green light (not to mention the incentive) to start chasing back down the quality ladder and back out the risk curve.

If 2018 marked the reversal of the QE dynamic that saw investors searching far and wide for any semblance of yield, 2019 may mark the reversal of that reversal – if you will.

If the Fed is done and the ECB is forced to rethink normalization in light of weak econ across the pond, it “raises the likelihood of a generalized decline in yields taking place across asset classes this year in a reversal to last year’s increases” – to quote the same JPMorgan piece we highlighted early Tuesday.

Don’t forget that the world is still flooded with negative-yielding fixed income. In fact, we’re back to 2017 levels on that score, with the global stock of NIRP debt jumping nearly 50% since Powell’s “long way from neutral” misstep in early October.

NIRP

(Bloomberg)

When you combine that dearth of yield with the restoration of the monetary policy put, you come away expecting yet another dash for “trash” – as it were.

And indeed, that manifested itself in January, when the Fed’s dovish pivot catalyzed a ridiculous rally in, for instance, USD high yield. Junk kicked off 2019 with its best month in years, returning more than 4.5%.

HYReturns

(Bloomberg)

CCCs scored big, logging their best month in nearly three years.

CCCReturns

(Bloomberg)

Spreads tightened dramatically, rallying some ~100bps on the way to retracing roughly half of Q4’s widening.

OAS

(Bloomberg)

Needless to say, this opened up the market and encouraged new supply as borrowers found willing buyers amid a suddenly euphoric market mood.

Is all of this justified? Well, that depends on how you see things developing from here. If you ask BofAML’s Oleg Melentyev, the risks are skewed to the downside after January’s rally. “Strong rallies should lead to less, and not more optimism”, Melentyev warned Friday.

You might recall that after the December turmoil, BofAML’s US HY strategy team suggested that if history was any guide, junk was set to rally. Specifically, they noted that “all other nine instances when HY sold off by more than 200bps in three months, as is did in Oct-Dec 2018, the market proceeded to rally in every single one of them.”

In other words, that was an easy call to make. Now, though, things aren’t so clear cut.

“For the market to continue to rally from here, one needs to be convinced that key conditions that substantiated materially tighter spreads last year could be replicated going forward… including earnings growth comfortably above 20% yoy pace, US economy growing well above potential, synchronized global growth, pervasive fear of rising rates and absence of fear of rising credit losses”, Melentyev goes on to write.

Obviously, none of those are completely safe assumptions, let alone all of them at once. And while BofAML isn’t ready to change their forecasts quite yet, the bank’s HY team sounds more than a little concerned that the next leg for the market could be wider.

We’ll leave you with a short excerpt from the note (dated February 1) which we think is especially well articulated and thus doesn’t require any further editorializing on our part:

Based on this understanding, we think the next 100bps from here are going to be much harder to achieve on the way tighter rather than on the way wider. In other words many things need to go right for the first scenario to play out, but only a handful of things need to go wrong for the second one. And while it could be said that this is a good example of cognitive dissonance, i.e. human brains are just wired this way to be more concerned about the downside, the difference is that sometimes you are compensated for this skewed perception and other times you are not. After a 100bps rally in HY spreads over just one month, we do not think the case is strong for this compensation to be there.

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