11th October 2018

All the makings of a systemic crisis

iTraxx Main

74.6bp, +2.8bp

iTraxx X-Over

298bp, +8.6bp

🇩🇪 10 Yr Bund

0.52%, -3bp

iBoxx Corp IG

B+133.1bp, +1.6bp

iBoxx Corp HY

B+405bp, +13bp

🇺🇸 10 Yr US T-Bond

3.16%, -6bp

🇬🇧 FTSE 100 [wp_live_scraper id=”17″], [wp_live_scraper id=”18″] 🇩🇪 DAX [wp_live_scraper id=”19″], [wp_live_scraper id=”20″] 🇺🇸 S&P 500 [wp_live_scraper id=”21″], [wp_live_scraper id=”22″]

Spectre of higher inflation/yields shake markets…

We lived through the tremors which came from the Brexit vote, Trump’s presidential win and his administration’s many policies including problems in US foreign policy around Iran, China and Russia – and more lately the potential for an EM crisis sparked by ructions in places like Turkey and South Africa. Italy continues to be a thorn in the side, too.

But all have been surpassed and/or exacerbated, by the fear of higher debt servicing costs.

And we have basically written off the year. Ouch! The big falls in the equity markets have us all concerned and many running scared. We have been here before and recovered but the driver(s) for the latest sharp falls might be a little more sticky than previously. That big driver is US domestic inflation and the rise in interest rates as their rate policy heads back to more normal levels. It might be the straw that finally breaks the camel’s back. Higher levels of inflation are what the policymakers were willing for over the past few years. It’s what investors were trading (risk on) as it remained persistently elusive.

Well, inflation is seemingly taking a bit of a grip as the economy nears (or effectively is at) full employment. The rapid rise in market rates on the back of it is coming close to busting any optimism that we might have had about managing to play out 2018 without having to think too much about it. We’re feeling the chill of it now, such that the only hope we might have is some spurious data points in the US which suggest that the economy isn’t going gangbusters.

As if to demonstrate the apprehension in the market, US equity futures were pointing to opening losses of 1% again on Thursday, before the sharpest of rebounds (to flat) after CPI came in at 2.2% in September year-on-year, below the 2.3% expectations. It was only a temporary reprieve and at the European close, US equities were around 1% lower again.

If we don’t get some respite soon, these moments have a habit of becoming systemic and potentially leading to a financial crisis.

There is flight from equities but it is not necessarily all flowing to safe-havens. There is obviously an element of it, but investors are cognisant of the fact that the Fed is in a hawkish mood (despite Trump’s protestations) and rates/yields will likely be going – or will attempt to go – higher, absent a full blown global financial crisis. Equities have dropped hard therefore as relative value is also reassessed. And those safe havens are not bid up as we might have anticipated given the proportionately large falls in stock markets.

Maybe we’re seeing some support for credit in these early stages where higher inflation spooks rate and equity markets. It might explain the recent outperformance of the asset class. Macro is mixed but the slowing trajectory in Europe is no deal breaker for the asset class.

Getting funding away might be a problem, but the corporate sector isn’t exactly parched of balance sheet liquidity. So there ought to be no sense of panic that the funding window is closed. Credit rating transmission risks are limited. Corporate bonds are illiquid – very, and so there will be few sellers as rebuilding positions will be costly.

For the moment, it makes sense that corporate credit is outperforming, helped by a large dose of technical support.

A systemic financial crisis will eventually undo all that.

When it rains, it really pours

The global markets are experiencing their own dose of climate warming. Another big down day in the US (at the time of writing) followed that 3%+ fall on Wednesday and the weekend can’t come quickly enough. The S&P index, having been up 10% for the year just over a week ago, is now barely 4% higher. The DAX index (a total return index) is down 10.5% YTD, and closing in on 5% of losses so far for this month. That’s carnage!

As with global warming, the big question is whether we have reached a tipping point. Obviously, for the former, there is no recovery. However, in financial markets, the concept of an economic cycle is well established. Some are pointing, though, to this being possibly being the big one – or presaging something more sinister than what markets have encountered before.

It’s difficult to tell how it might play out because we have never encountered this mish mash of policy response to a financial crisis before. Coordinated multi-trillion dollar QE, negative interest rates, distorted markets, manipulated markets and a consumer and corporate debt binge which looks like it just might unravel into a bigger crisis than the last great one.

Is it payback time?

Calling for calm heads

For credit, our view is to wait and see. That’s usually easier said than done especially when that tap on the shoulder inevitably becomes an enquiry has to how one is hedged for the downside. So we might see some pressure on higher beta markets from now (they’ve held up remarkably well), especially say Italian and other peripheral contingent convertible debt.

As for Thursday, European markets were lower again, in a sense playing catch up to the dire close in the US.

The DAX was off by 1.5% in the session with any tentative recovery brushed away as US equities lurched lower. The FTSE dropped by almost 2%.

The flight to quality trade saw the US 10-year better bid and yielding 3.16% (-6bp) with the equivalent maturity Bund off the session highs (in price) to yield 0.52% (-3bp). All very measured, we think. Italy got a €6.5bn debt auction away but paid the highest yields for around five years for the privilege, and the 10-year BTP closed to yield 3.58% (7bp).

The credit primary window was slammed shut for which no one will be surprised. The next corporate bond deal will now possibly be next week’s business now. Elsewhere, it was about buying some protection as a hedge and maybe offloading some debt of afflicted names (if the bid was anywhere near sensible) – and then just staying sidelined.

For the indices, protection costs rose more sharply than in the previous session amid greater concern within the credit market as investors sought to hedge some risks. It left iTraxx Main to close up at 74.6bp (+2.8bp) and X-Over 8.6bp higher at 298bp.

In secondary cash, relative stability again. There was no panic and we edged only a little wider. At the close, the IG iBoxx cash index was just 1.7bp wider at B+133.1bp with month-to-date returns at -0.2% (YTD just -0.9%). Equity investors will be envious. There was weakness specifically in subordinated bank debt felt most keenly in the CoCo market.

In high yield, we saw a weakness filter through versus the unchanged previous session as those weaker equities weighed on the market. At the close here, the iBoxx index closed at B+405bp (+13bp).

Have a good day.

For the latest on corporate bonds from financial news sources, click here.

Suki Mann

A 30+ year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on CreditMarketDaily.com.