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Thoughts on the Credit Market from the Trading Desk of AAM


The 10-year Treasury just slid to 2% (and below temporarily) for the first time since November 2016. Why? In our eyes, it has about as much to do with technicals as the painting “Dogs Playing Poker” (by Cassius Marcellus Coolidge). It’s all geopolitical and changes all the time. A recession very well may be coming; a future recession is always a market certainty. Trying to stave it off through years of quantitative easing has the potential to make the next recession more pronounced or extend its duration.


What's pushing markets around?



  • Central banks around the world continue to prop up their economies and markets by driving rates lower and leaving them there (negative in some cases). Inflation growth (or any inflation) is almost nowhere to be found, which seems reasonable to think cutting rates would help, but more data is showing cutting short-term rates is having little to no impact on inflation. It seems the market is broken but people in charge haven’t realized it yet.

  • Negative headline news as Iran shot torpedoes at tankers and downed U.S.-owned drones in international airspace.

  • Multiple trade disputes between the United States and other countries continue to roil global supply chains. Diversification is long overdue but does contribute to fears of global economic slowing.

  • Trade policies and political overtures (including an upcoming election) within the United States are compounding to make the job of CEOs and CFOs harder as they aren’t sure whether to expand or hire as rules could change either way at any time.

  • The 10-year Treasury has rallied 124 bps (basis points) from recent highs in November 2018. That is a 38% cut in yield in essentially 7.5 months as trade issues compound and the global economy continues to have issues pushing alternatives for yield to once unthinkably low levels – one of the main drivers of the 10-year Treasury.

  • Rate analysts are scrambling to update their 2019 forecasts for Fed action/rate expectations. On Thursday (6/20/2019), TD Securities said they now expect 75 bps of cuts this year and 25 each in three meetings next year with the 10-year Treasury ending around 1.3%. Others joining the parade were PIMCO calling for 50 bps next month and Goldman and Citi also calling for 50 bps by the end of the year. Guggenheim updated their forecast for the 10-year Treasury to 1.5%. The funny thing about all of this is almost EVERY rate analyst had the 10-year Treasury forecast to finish 2019 higher than where it started.

  • If we are listening to analysts, Jeffrey Gundlach – who was one of the few who called this year’s rally in Treasuries – stated just last week that, “If the government would not get involved in the manipulation in bond yields, the U.S. 10-year Treasury would rise to 6% by 2021.” However, we believe that’s unlikely to happen. He also stated, “Three months ago the Fed predicted totally different policy than where they are now. How can they predict 2020 policy with a straight face?” and that he pegs the chances of recession are 40-45%. He also wants to be right…but worth considering.

  • All of this nonsense and the equity markets are making new all-time highs. Something tells us caution is warranted in all markets…. Hasn’t Japan and the European Union shown us this movie already? I guess we’ll see.


 


So…Credit Spreads should be widening as corporations feel the pain of a coming recession, right?


Spreads are not reacting like a recession is coming, at least in any meaningful way…yet. One would expect that as the risk of corporations earning less – and therefore their ability to repay obligations more impaired – there is more risk in owning risk assets such as credit, especially that of lower-rated more highly-leverage companies.


Global credit continues to be bought by some central banks or surrogates giving internationally-based investors no choice but to buy U.S. Treasuries and credit – keeping a lid on any spread widening regardless of inherent risks involved to investors. Any widening generally has been very modest this time around. Given that credit spreads are currently at +123 according to the Bloomberg Barclays U.S. Aggregate, spreads can indeed move tighter from here, and they have before. (See the Chart for Credit Spreads below)


There has been good institutional demand for almost every new issue priced this year with most deals being well oversubscribed and trading tighter in the secondary coming at little to no concession to existing paper. This could be because of the very light inventories dealers hold and their refusal to sell much short to “make a market” or satisfy their own clients’ demand for supply, instead depending on existing customers to hit bids on demand from their holdings. The lack of supply not only makes new issues more sought after but drives prices on secondary paper higher.


Viewing recent historical relationships between credit spreads and 10-year Treasuries, most of the time when Treasuries trend lower, spreads widen and vice versa. There are obviously several global reasons that “it might be different this time” (as stated above), but we tend to lean toward the opinion that it ultimately probably won’t be different this time.


Credit Spreads Since 2010


cole1_062419Source: Bloomberg


10-year Treasury since 2010


cole2_062419Source: Bloomberg


In addition, the spread between BBB and riskier BB paper is only about 82 bps and vehicles for leveraged loans (again to more risky borrowers) are commonplace, although not widely owned by retail investors.


All of this and equities are at all-time highs. The manipulation of markets is extraordinary.


So how do we play it from the desk perspective?



  • “This too shall pass.” Environments like this are not the end of the world by any means but something that should be taken seriously. It would probably be a great idea, if we could, to just turn off the constant barrage of news for a bit to limit the “noise,” if nothing else.

  • Stay relatively light in terms of inventory levels, keep holding periods short and stay hedged; but not with Treasuries, when at all possible, as the diverging correlation may get worse in the range of credit quality that investors we work with most often look for.

  • Keep a watchful eye on credits for cracks in spreads/prices to take advantage of falling markets. We think it’s possible to navigate any meaningful sell-off in credit if properly prepared.

  • Continue to explore opportunities for additional liquidity and sources of bonds and relative values in certain names in corporate credit to help weather the storm.


For investors in this market environment?


In our opinion, it doesn’t pay to sit on the sidelines waiting and waiting and the (opportunity) cost is generally unacceptable for investors. If a recession is coming, moving to safer assets (all dependent on risk tolerances of the investor as to what that means and how much duration is involved) could make sense. If investors aren’t sure a recession is imminent, think it won’t last long, or simply have income needs that have to be met, other strategies might be better. In our view, those alternative strategies include legging into trades, looking for good relative value ideas versus available alternatives and building cross-product ladders (to name a few), all while keeping an eye on portfolio duration and credit quality – instead of blindly “reaching for yield.”


CRN: 2019-0620-7504R


AAM was not involved with the preparation of the articles linked to in this email and the opinions expressed in these articles are not necessarily those of AAM.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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