Hans Lorenzen of Citi Credit Research in a new report notes that we enter an era which hardly a fairy tale ending — Looking beyond the immediate implications of the FOMC and the concerns over China, he thinks ‘a Goldilocks era in credit is coming to an end.’ Here is some more commentary from the interesting note titled ‘Life in the post-Goldilocksian era’.
This week must quite literally have scared the living daylights out of anyone still living the Goldilocks fairytale. The era where the temperature of the global economy was just right for credit — cool enough to sustain the central bank stimulus, but not so cold as to trigger the wave of defaults associated with a deeper recession — is coming to an end.
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To our minds there is little doubt that we are now transitioning to a period where markets again have to reflect the risks on either side of the Goldilocks scenario. But does that imply a much bigger repricing of credit?
Regular readers will know our deep-seated scepticism that valuations reflect the fundamental long-term issues. There is a chance (indeed, a growing one) that markets are now in the early stages of redressing the imbalance. For those purposes, it would be all too easy to rant about the soaring Shibors, China CDS at a two-year high, record EEM ETF outflows, Mansion House speeches and — last but not least — gapping yields.
Transitions are always fraught with danger. Even when your positions have adjusted to reflect the new realities, you worry that those of your peers won’t. Fear begets fear. We can’t pretend to have much conviction: picking the turning point as much as anything is a game of second guessing. But ask us to put our heads on the block and our sense remains that this ‘isn’t it’ — we still see it as a selloff within the range, rather than the unwind that takes us into a tail scenario.
Lorenzen’s principal considerations are:
- The Fed has probably wanted to tackle the perception of a growing asset bubble risk and address market pricing lagging its guidance. There was little to suggesting the FOMC statement or the economic projections that the Fed has brought forward the timing of rate hikes — in fact one voting member shifted from 2014 to 2015. However, unlike when the Fed ended QE1 and QE2, there is no sign of a pickup in inflation expectations currently. The Fed is forecasting higher inflation, but it remains a forecast for now. Actual inflation and inflation expectations are falling. That suggests that the Fed will be less happy to see any further rise in yields from here, now that they have caught up with guidance. 10yr US yields are now only 20bp from our strategists’ end-of-year forecast (which is based on tapering from September), implying yields should rise at a rate of a just few basis points per month on average from here.
- By the same token, Bund yields have already overshot our rates strategists’ targets. The economic outlook does not merit higher yields — if anything the ECB may have to cut rates again later this year.
- Rampant credit growth in China continues to pose a downside risk to the medium-term outlook. Chinese policymakers may well keep short-term liquidity comparatively tight, but the reported intervention overnight which triggered a big drop in interbank rates suggests that the PBOC will act to keep the situation contained.
- It is clearly difficult to judge how much money has yet to flow out from EM funds. But equally, the value that is opening up is hard to dismiss. Many lower-beta bonds and indices have dropped the best part of 10 points in just a few weeks. If US yields do find something of a range over the coming days, then we suspect many will be tempted to step back in.
- Within European credit, the pain has clearly spread from the CDS market to the cash market. But even in Thursday’s selloff there was little indication of a panic. For instance, our HY traders reported seeing hedge-fund selling, but the street appeared much more balanced than just a week ago. There isn’t perhaps the conviction to actually stand against the widening, but positioning seems less skewed and volumes are comparatively light. Crucially, we’re still not seeing much evidence to suggest that the outflows in the US and EM have spilled over to European credit.
- We have highlighted the striking correlation between European spreads and US yields in recent weeks. The relationship still holds extremely well. However, there are signs that the sensitivity of credit spreads to each basis point move in Treasuries is diminishing — compare Thursday’s rise in yields to the widening in iTraxx Main. Moreover, now that the entire market is screen watching US yields by the minute, we don’t think the two-week lag implied by the chart will hold going forward — the relationship should be synchronous from here on.
- Most importantly of all: the money is still there. The key finding of the piece ‘Too Much Money, Not Enough Assets to Buy’ from earlier this year was that even with aggressive tapering from September, the net supply of new securities across global financial markets this year will be the lowest in at least a decade and a half. A pullback in demand for risk can cause a correction in the short-term, but over the coming months the supply-demand imbalance should remain extremely favourable to asset prices.
Citi is sticking to the view that credit spreads will ride out the volatility and actually recover somewhat over the summer. But in the post-Goldilocksian era, fashions change. Carry trades are likely to look decidedly out of vogue. Even tapering aside, we see numerous sources of volatility going into autumn that would make people think twice about running beta for carry: the US debt ceiling, political uncertainty post the German election, downside risks to Chinese growth , and the weakness of the European economy going into 2014. In the post-Goldilocksian era avoiding the consensus is crucial.
Right now, that says two things to the analyst. First, avoid sitting on index protection (as an overlay for cash longs). Indices are liable to snap back as soon as all the EM and other hedges that have been put on through iTraxx and CDX are unwound. Second, use the widening in recent weeks to barbell between cash and higher beta bonds says Citi.
Lower-beta (core non-financial) bonds have started to drift a little, but remain far tighter than what is implied by movements in the rest of the market. In a retracement they would almost certainly lag by an equal amount. Conversely, if the sell-off were to translate into actual outflows, then suddenly the (risk-adjusted) pressure would shift to the low-beta part of the market, as people are forced to sell what they can — just as we have seen in EM and in the US in recent weeks.