24th March 2019

On a wing and a prayer

iTraxx Main

70bp, +3.3bp

iTraxx X-Over

283.6bp, +16.9bp

🇩🇪 10 Yr Bund

-0.02%, -6bp

iBoxx Corp IG

B+140bp, +1.4bp

iBoxx Corp HY

B+443bp, +6bp

🇺🇸 10 Yr US T-Bond

2.44%, -10bp

🇬🇧 FTSE 100 [wp_live_scraper id=”17″], [wp_live_scraper id=”24″] 🇩🇪 DAX [wp_live_scraper id=”19″], [wp_live_scraper id=”25″] 🇺🇸 S&P 500 [wp_live_scraper id=”21″], [wp_live_scraper id=”26″]

The sense of crisis is back…

Not since 2016 has the 10-year Bund yield dropped below 0%. It took a poor set of Eurozone PMI data on Friday – later added to by weak data from the US – to help tip that yield over the edge as it was confirmed that the all-important and crucial German manufacturing industry is in recession – as others across the Eurozone are too. It was all very dramatic.

The last time that yields were here, duration was better bid in anticipation of the ECB’s QE programme (June 2016). The ECB is absent now and we’re heading, effectively unassisted, for that record low of -0.13%. Worse, we’re not sure how further policy accommodation is going to help in the long term – but we know that it is coming. After wasting the previous couple of years failing to restructure anything, we’re punch drunk on liquidity accommodation and we will need more just to stand still.

The 3-month/10-year US Treasury curve inverted (flat at the close) and can be an indicator of a potential recession to come. We would suggest that years of QE and market manipulation have sullied the outlook and classic linkage in that sense, although quite clearly there is an economic slowdown occurring right now.

The immediate reaction is going to be – and was – for lower equities, a bid for rates and moderate weakness in credit spreads as fears mount that single name (or otherwise) event risk might hit the market. So we will likely see a prolonged period of volatility but as this initial data ‘shock’ is absorbed we will eventually settle in anticipation of the ECB (and others?) introducing some ’emergency’ measures to help limit market concerns and weakness. The ECB has plenty in its arsenal, but the effectiveness of it is open to question.

We’ve been here before and that might give us a clue as to how events might play out. Unfortunately, there is another factor to contend with. Brexit. This situation is extremely fluid but any shocks – like a ‘no deal’ by accident or not, and we might just be looking at a financial systemic event. So credit market investors potentially need to toe a fine line between piling in now (low underlying yields, low default rates increasing the lure of a bit of spread) or waiting until we get a policy response and find secondary market liquidity has evaporated.

We’re with the former in a measured sense. We don’t think the wheels are about to fall off the credit market. Higher beta risk still has its relative merits but we can’t see how it can rally if equities are persistently weak and/or volatile  Admittedly investors are still looking for yield, but the AT1 market has probably seen its best level – for the moment. In high yield, we think the same. A renewed push better will only re-emerge once we are through this period of recognition and adjustment.

We also happen to believe the -0.13% level will be tested soon enough. As suggested, it will not take much to get there. That is going to come when the broad global macro weakness delivers a bigger kick as we anticipate. Lest we forget, we also have the unresolved China/US trade talks that could end nastily.

Recession stalks the market

A global manufacturing sector recession that will infiltrate all areas of the economy is now the default position. The broader macro-economic environment is also under immense pressure and the incoming data over the next few weeks is only going to confirm our worst fears. How bad is going to depend on issues like Brexit in Europe and US/China trade talks, for instance. Longer term issues like the industrial pain which will reverberate through the German auto industry including its suppliers is going to mean some sort of restructuring is going to be needed. And so on. There is no easy way out this time.

Just as well we have some performance in the bag to fall back on. That’s the case in the corporate bond market. Benchmark investors will be more fearful than absolute return ones, given the latter will gain some comfort from the rally in the underlying. Emerging markets, though, are also going to be in the firing line, having managed to trade tough a relatively benign period since the turn of the year.

So weakness in US and Eurozone manufacturing came with the PMI surveys and we ought not to have been surprised by it. Macro has been teetering for a while. The markets recoiled. Equities might have had what on the face of it looked a more measured response to begin with, but we then had more severe declines. The Dax ended up losing 1.6%, the FTSE underperformed and lost 2% while the US markets were up to 2.3% in the red.

Rate investors, of course, were aggressively bidding up their market – with spectacular results in the session. The bid for safe-haven had the 10-year Treasury yield ratchet lower by 10bp to 2.44%, the Bund yield in the same maturity was down at -0.02% (-6bp and just off the session lows 0f -0.03%!), while the 10-year Gilt yield dropped to 1.01% (-6bp).

In synthetic credit, the iTraxx indices reacted with investors better buyers of protection pushing Main up to 70bp (+3.3bp) and X-Over up to 283.6bp (+16.9bp) at the close.

As for cash, no panic but the usual extremely defensive bid from the Street (“why should we the on the risk?”). That meant some seriously wide marks for the higher beta risk in particular. Flatter rate curves might be hammering bank stocks, but they will also translate into weakness in their credit spreads with the bank capital sector most impacted.

So we closed with the Markit iBoxx IG cash index at B+140bp (+1.4bp) although we would think that there might be a greater follow through (weakness) on Monday. The rally in the underlying pushed total returns for IG credit, year-to-date, rose… to a stunning 3%! As expected, there was weakness in the AT1 market with the index left at B+600bp (+16bp) with returns year-to-date dropping to 5%. Few will worry at that figure.

It was the same in the high yield market, but we could expect more weakness on the follow-through on Monday. The index closed at B+443bp (+6bp).

As for this week, Brexit headlines will be a focus us in Europe although we don’t think ‘Meaningful Vote 3’ will happen. Elsewhere, we’re light on economic data while high level US/China trade talks resume in Beijing.

Have a good day.

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.