Credit Investors Are Suddenly Extremely Worried About Central Banks

On one hand, credit investors have never had it better with IG credit spread at record tights and junk bond yields sliding to 3 year lows

On the other, and this is linked to the above, they have never been more nervous, and as the latest Bank of America credit investor survey shows, more worried about the Fed in general, and "Quantitative Failure" in particular.

But why, if as so many claim, the Fed has nothing to do with the the return of risk assets? Ignore that, it's rhetorical.

As BofA's Barnaby Martin writes, August’s survey shows a marked change in the Wall of Worry, in which "Quantitative Failure" has now emerged as investors’ top concern (23%), up materially from June’s reading (6%). The reason for the sudden spike in central bank fears is that Investors say that a backdrop of the ECB ending QE next year, while inflation remains sub-par, has the potential to rattle the market’s confidence.

The sudden fear about "QF", or major policy error, means that the recent biggest worry, “Bubbles in credit” has been downgraded to second biggest concern (down from 33% to 21%) while those worrying about “yields rising” increases slightly (from 12% to 14%).

The chart above shows that at the top of the Wall of Worry for both high grade and high yield investors are:

  • “Quantitative Failure”, “bubbles in credit” and “rising yields”
  • Interestingly, almost no investor worries now about “populism” or “low liquidity”
  • Bubbles in credit still features among the top worries, but is well down from June’s reading (in high-grade it has fallen from 33% to 21%)

Looking at the menu of possible ECB actions, around 30% of high-grade investors say it will be a policy mistake if the ECB raises depo rates to 1% over the next few years. 20% say it will be a policy mistake if rates are raised to 50bp and 11% say a policy mistake will happen if depo rates are raised to just zero. Thus, BofA notes that credit markets remain highly sensitive to expectations about ECB rate hikes going forward (BofAML base case is for first ECB rate hike in Spring ’19). The chart below is a reminder, however, that it is the level of rates vol (not rate level) that has been key for credit spreads over the last decade.

Curiously, many of these adverse sentiments about central banks' screwing up were first observed, in more diplomatic language of course, by the TBAC's latest refunding presentation, in which the most important advisory committee in the US laid out the following three "non-linear risks" that emerge from central bank normalization

  • Risk premium compression. Central bank balance sheet expansion, declining bond risk premium, and lower yields induced rising investor bond demand and tighter credit spreads. Corporates filled the demand gap with a surge in borrowing used for equity buybacks. Pure financial engineering.
  • Risk Premium decompression, accelerators: Small increases in yields can potentially lead to large changes in risk premium. Credit is the key transmission. Pro-cyclical behavior of investors who ‘piggy backed’ central bank purchases and ECB tapering are possible accelerators to the rise in US risk premium in a tail risk event.
  • Let markets clear. A downside risk in a stress scenario is a meaningful decline in risk assets. But it isn’t systemic. Banks and households have not leveraged to higher asset prices. It is a financial  engineering shock.

The TBAC even laid out the possible sequence of adverse events, when in a slide it explained how a "stress scenario" could play out: the "amplification from normalization could possibly come from wider credit spreads and be transmitted to equity buybacks and valuations." In other words, higher yields, higher credit risk premium, higher volatility, lower risk prices, market crash.

The BofA survey provides some more context to the TBAC concerns, because as Barnaby Martin explains, "for the majority of IG investors (36%), the “game changer” for the current bullish credit cycle would be the end of QE buying by the ECB."

Indeed, it is the ECB's QE end, not the balance sheet tapering by the Fed, which is increasingly perceived as the catalyst that can finally "ruin the party."

Away from IG, however, for the majority of HY investors, the key break factor would be a Eurozone growth slowdown and/or a rising possibility of a recession. Ultimately these two concerns are the same: reduced liquidity into a recession, the same event that happened in the summer of 2011, when the ECB hiked rates only to unleash the most acute part of the European sovereign debt crisis, culminating with Mario Draghi's vow in July 2012 to do whatever it takes."

BofA also points out that while many hate tight valuations, few see them as a catalyst for the credit cycle to turn. In other words, absent a catalyst, yields can continue grinding even lower until something snaps.

Finally, any upcoming "quantitative failure", or even simple policy shift would have a just as dire impact on that other potential risk contagion source: emerging markets. As Credit Agricole's Valentin Marinov writes in a note today, the approaching decisions by the ECB and Fed on whether to tighten policy, could heighten risk aversion and drive investors out of emerging-market currencies. Such a move would unravel the profitable developing-nation carry trade, which has gained amid subdued volatility and which has served as a souce of funding for many of the credit (and equity) trades.

The result would be the end of an unusual period for foreign-exchange traders, where volatility in major currencies has exceeded that for emerging markets. Needless to say, the volatility during this period would surge for everyone.

"Higher implied volatility reflects growing uncertainty about the outlook and usually comes hand-in-hand with bouts of risk aversion," Marinov said. "EM volatility could re-couple with G-7 volatility if the event risks in September and October force investors to cut their risk exposure and thus unwind carry trades."

Of course, lurking at the bottom of it all, is the upcoming debt ceiling negotiation in September, which could leave the US government paralyzed, the Treasury in technical default and the market violently "roiling" in the words of SocGen.

In short, the calm before the storm is about to end.


GUS100CORRINA venturen Thu, 08/03/2017 - 18:12 Permalink

Credit Investors Are Suddenly Extremely Worried About Central BanksMy response: Credit Investors should not be just worried, they should be utterly terrified. The entire world financial system is a GIANT PONZI scheme waiting to unravel. All that is needed is a catalyst!!I want to suggest that the catalyst may be the US SENATE. These LEGISLATIVE DUMB ASSES with SHIT FOR BRAINS group of DESPOTS with REPROBATE MINDS will unleash HELL on AMERICA if they keep attacking this sitting president. President TRUMP is America's Nineveh moment. These legislators need to STAND DOWN and SHUT UP or their POLITICAL CAREERS will be SHORT LIVED just like the American republic they were elected to serve.

In reply to by venturen

Clock Crasher Thu, 08/03/2017 - 18:02 Permalink

New normalThis time its differentBonds are matter of national securityThere still a lot of wealth to transfer to keep this going for many many yearsThere is still a lot of meat on the bone of the tax payerGet me a DeLorean and send me back to 2009 to get me some 10 cent BitcoinThink about this. Bonds are IOU dollars. The Dollar falls six months in a row. Where did bond rates go?

Clock Crasher Thu, 08/03/2017 - 18:07 Permalink

Judging by recent behavior Trump will offer no resistence to debt cieling increasing in whatever amount pushes us out beyond the 2018 midterms or longer.Prepare for a Gold flash crash of 2% the day of and 10% follow through decline on the news.

TeethVillage88s Thu, 08/03/2017 - 18:23 Permalink

And WSJ today says 401K balances & deposits are at all time high.

- So what is the Truth?

Q: define Investors, Zerohedge?

Maybe the weird small percent buying gold, silver, redoubts in New Zealand, Silo homes in USA? God-Damned Stansberry is still advertising his same message from 2010 on ZH Ads... perhaps he is your 'Expert'?? Porter Stansberry?

itstippy silverer Thu, 08/03/2017 - 19:20 Permalink

Who do the CBs have coverd?  Credit investors, credit traders, credit speculators, or all of the above?True credit investors, like pension funds and insurance companies, have been taking it in the shorts for almost ten years now without having to show the strain on their longterm models.  Sure, the notional values of their bonds have gone way up, making their models' performance look good.  But the interest on the bonds is for shit and has been for a long time now.  It won't be pretty going forward.

In reply to by silverer

bluskyes Thu, 08/03/2017 - 20:54 Permalink

Economic "growth" will end, because the springs of "units of account" are going to stop issuing these "units" so freely?Banking ought to be a crime, Central banking ought to be a hanging crime.Reminds me of a quote from some old guy. Something about central banks... issuance of currency... inflation... deflation... waking up homeless... But then what the hell did he know?

JailBanksters Fri, 08/04/2017 - 00:45 Permalink

I don't think soIf your Too Jewey to Fail, then you won't, UNLESSUnless all the Rothschilds Banks all go boom one after the otherBut what's more Important is the order in which they Fall.  

ds Fri, 08/04/2017 - 01:53 Permalink

CBs trying to stay co-ordinated in a multipolar world. The politics will break the co-ordination. CBs will at the last resort defend their currencies and sovereign bonds. CBs are silently accepting their errors but fear to taper to bring the universe of bonds and equities down.Risks have gone astronomical with deformed markets spinning on their own orbits. Credit Investors are only now getting worried ? Don't worry, spins are aplenty to kepp you in the deformed markets. Have not even talked about derivatives held not as hedges.