On common theme we’ve been building on lately as central banks work to monetize all net (and sometimes gross) government bond issuance in their respective jurisdictions, is that QE is destabilizing markets by sapping liquidity which in turn inhibits price discovery and creates volatility. This is on display in Japan, where 2 out of 3 dealers think the JGB market is impaired thanks to BoJ asset purchases and where many officials are beginning to get more vocal about the possibility that a lack of liquidity could have “dire consequences.” Similarly, market financing via shadow banking conduits has declined by nearly half since 2008 in the US, and with dealers unwilling to hold inventory of corporate paper thanks to tougher capital requirements, the stage is set for what the Center for Financial Stability recently called “an accident.” As a reminder, here’s what the SEC's Daniel Gallagher had to say recently about liquidity in the US corporate bond market (via Bloomberg):
Lack of liquidity in corporate bond market is “systemic risk” not addressed by regulators, SEC Commissioner Daniel Gallagher says in public remarks.
Gallagher cites 80% decline in corporate bond inventories among dealers and impact of higher interest rates on future trading needs; “that has accompanied a record level of issuance year after year since 2008 of $1 trillion-plus of corporate debt”
“I would submit to you that the lack of liquidity in our securities markets is a systemic risk,” he says at conference sponsored by Institute of International Finance.
Today, we get yet another warning about the increasing degree of illiquidity in fixed income markets, this time courtesy of UBS, who warns a Fed rate hike could open a “Pandora’s Box” for corporate credit spreads.
Pandora’s Box: Fed Tightening Is a Problem for Credit
One of the holy grails of corporate credit is the seemingly innocuous link between Fed rate hikes and credit spreads. Simply put: Higher Fed Funds -> Tighter Spreads. The rationale is intuitive enough. Fed rate hikes are initiated in the context of strong GDP growth and falling unemployment. The hikes are designed to skim some froth from the business cycle, while still allowing the economy to progress through productive investments. This serves to boost corporate profits, open capital markets and lower default risk, all of which support credit spreads. However, we are not convinced this relationship will hold in a post-QE world. Historical parallels and correlations of spreads to shifts in monetary policy expectations can find environments where Fed tightening equates to spread widening. But aside from the direct linkages of rates to spreads, a more fundamental concept is at play. The economic cycle and asset price cycle have diverged, with asset prices looking more like 1999 than either 1994 or 2004...
...the late 1990s and late 1960s demonstrate that a higher Fed Funds can lead to wider spreads in the context of a strong economy, high asset prices, and a lengthened economic cycle. These Fed rate hikes were commenced 98 & 77 months into these respective expansions, which compares to 71 months if the Fed hikes rates in June 2015. Notice as well that the pace of tightening was generally slower than average in these cycles, particularly in 1999. Hence, a fast rate hike cycle is not necessary to increase credit risk when later cycle dynamics are at play. Lastly, in the 1994 cycle, we did see decompression as IG tightened and HY widened. This is perhaps symptomatic of the greater beta of HY spreads to an unexpected shift in monetary policy.
The key takeaway is that recent short-term shifts in monetary policy alter risk premia more than expectations of credit fundamentals, leading to positive correlation spikes. The current divergence between market implied pricing of Fed Funds vs. Federal Reserve forecasts is then a clear risk for credit investors. A Fed that is more aggressive with respect to the pace of tightening will re-price credit spreads wider...
Importantly the evolution of asset prices can diverge from the evolution of consumer prices, as it has before in extreme cases during the US real estate bubble in the mid-2000s or the Japanese real estate bubble during the late 1980s. We believe this divergence has occurred today, with asset prices more characteristic of later cycle dynamics. We present two measures below on US equity prices that illustrate we are closer to 1999 than 1994 & 2004. Margin Debt as a % of GDP is near record levels, and higher financing costs will make that calculus less attractive. The total value of the S&P 500 relative to GDP is also at frothy levels going back to the late 1990s and 1960s. But this is surely not the only metric to investigate. Yield seeking behavior has led to significant market gains in fixed income assets. Indeed, while equity prices look expensive relative to real economic activity, they are arguably cheap relative to bond valuations. S&P 500 earning yields are similar to BB/B bond yields, as opposed to A/BBB yields historically, indicating excessive yield-seeking behaviour in the face of reduced bond market liquidity.
We are left to wonder what happens in the event UBS is correct and a Fed rate hike triggers widening corporate credit spreads in a corporate bond market devoid of liquidity. Could it indeed be the case that the Fed’s highly anticipated “lift-off” will serve as the catalyst for credit market carnage?