It's a new year… and just like last year, we greet it with not only record highs across equity markets, but a new rip tighter in spreads: as shown below, on Thursday the Barclays corporate index spread hit just +90 bps the tightest since Feb '07.
And, as BofA's Barnaby Martin writes in an overnight note, what should be clear already is that this credit cycle won’t simply roll over and die of old age. "Far from it, we think. In fact, we believe one underappreciated risk by the market in 2018 is that Euro credit spreads get squeezed to eye-wateringly tight levels, spurred on by a still-supportive central bank backdrop."
Yet what makes the ongoing grind all the more confusing is that all major central banks are either in the process of hiking rates, shrinking balance sheets and QE, or at the very least signalling the limits to their monetary policy.
What's going on?
According to Barnaby, "the current backdrop feels very reminiscent of the Greenspan era of 2004-2006. Back then US interest rates rose 17 times. Yet, financial conditions remained loose and interest rate volatility fell to very low levels precisely because Fed monetary tightening was so predictable and patient: rates generally rose by 25bp at each meeting."
And, as discussed here previously, fast forwarding to today reveals that the same backdrop has taken hold: namely that despite hawkish overtones by central banks, financial conditions have again been loosening over the last year (Chart 1).
But have central bankers truly learned nothing from the previous two bubbles? Well, according to BofA, burnt by successive market tantrums, central banks have learned to plead for the market’s patience as they exit their extraordinary policies. For now, this “gentleman’s agreement” between markets and central banks is keeping rate volatility near record lows, even if yields themselves are moving higher.
But what, if anything can pop the central bank bubble?
That, according to BofA - and everyone else who watches the daily market meltup in stunned silence - is the question: "Absent a recession what is most likely to end the central bank induced bull market for risk assets?"
According to Martin, it would clearly need to be an outbreak of more hawkish – and less predictable – central banks. Specifically, greater rate volatility is what would ultimately break the great reach for yield trade. Here, the strategist believes that there are four things that could provoke a more hawkish-than-consensus narrative from central banks:
- higher than expected inflation
- a clear lack of reflation
- rising financial stability concerns, and
- protectionist politics (leading to either supply-side inflation or a push for corporate releveraging).
Below is a quick walkthru the 4 things that could pop the bubble, according to BofA.
1. Higher than expected inflation…
The raison d’être of central banks is price stability. Should inflation show signs of returning to around 2% then the risk becomes that central banks would no longer need to be so predictable and patient in raising rates. This would likely drive much higher levels of rate volatility and end the benign conditions for Euro corporate bond markets.
BofA economists have written much on the risks of inflation over the last few months. Wage growth looks likely to rise first in the US given labor supply shortages. While this wouldn’t immediately imply wage growth in Europe it could nonetheless push inflation expectations up in Europe. This in itself could drive higher levels of rate volatility in Europe.
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2 …or a lack of reflation (and Quantitative Failure)
On the other hand, markets may lurch back to debt sustainability worries if inflation refuses to rise that much. In Europe, core inflation has now come in at 0.9% for three months in a row, reminiscent of the end of 2016. A slower than expected rise in inflation – at a time when central banks are exiting stimulus with little in reserve to fight the next downturn – could shatter market confidence, leading to a sell-off in risky assets. Herein lies the Quantitative Failure risk for markets in 2018.
Note in Chart 9, the top risk from our Credit Investor Survey was Quantitative Failure in August and October last year. And in December, although Bubbles in Credit was the top concern, 11% of credit investors still cited Quantitative Failure as their top worry.
3. Rising financial stability fears
If it’s not inflation (or lack thereof), then central banks may simply feel that the time is right to sound more hawkish in order to preserve financial stability and prevent a misallocation of capital taking hold. After all, stable rates encouraged the proliferation of leverage in the run up to the Global Financial Crisis of ’07-’08.
Recently, more central bankers across the globe have been opining on the risk of asset bubbles and pointing out high equity market valuations, for instance. In Euro credit markets, we reflected on the worrying pricing points that were developing towards the end of last year: such as AT1 bonds almost yielding less than the dividend yield on the Euro bank stocks index. And note now, after a further rally this year, AT1 yields are about to dip below 4%.
Over the last few months it’s been M&A which has taken a step-up in Europe, no doubt supported by firms’ access to cheap debt issuance. In particular, French M&A has visibly risen and is now at a decade high (Chart 10) with Macron’s Presidential win driving a corporate feel-good factor in France. But as Chart 11 shows, this is contributing to France’s corporate debt-to-GDP rising to conspicuously high levels now, especially compared to corporate leverage in other Eurozone countries. And recently, the Banque de France has begun to highlight this worrying trend more and more.
The risk is that as more of these heady pricing points appear in the market, central bankers are forced to sound hawkish (and less predictable) to stop a rerun of the past.
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4. Protectionist politics
Finally, it could be populism that upends the central bank support for credit markets. Populism was the proverbial dog that didn’t bark in 2017, as investors shied away from a Frexit vote. The relief has helped send European policy uncertainty down to levels last seen in ‘14. But that doesn’t mean the populism narrative is dead. Far from it, we think.
Income and wealth inequality continue to be important catalysts stoking resentment towards mainstream political parties. And in an era of central bank QE, financial assets have strongly outperformed real assets since 2012. As the charts below show, income inequality has risen across the world over the last nearly 40 years.
In Europe, while the rise in income inequality has been at a slower pace than in other counties – such as the US – it has nonetheless been noticeable (Chart 12). In 1980, for instance, the share of national income accounted for by the top 1% of earners in Europe was just under 10% (Chart 14). Today it has risen to 12% (yet it has risen to 20% in the US, Chart 15).
But populist parties’ views are often dominated by the insular thinking of “us first” as opposed to agendas that continue to foster globalization. While the populist narrative is becoming more aggressive, confrontational and xenophobic as time goes by, the risk is that some of this rubs off on mainstream parties as they try to win back voter support, and they start sounding more populist themselves. As Chart 16 shows, more countries experienced declines in “freedom” in 2017 compared to those that registered gains in “freedom” – the 11th such consecutive year.
This amounts to a test of globalization, in our view. And a more mercantilist approach to global trade could create less efficient supply chains for corporations, which would be inherently inflationary. And by default, this could provoke a more hawkish message from central banks.