Jeremy Wharton, Church House joint CIO, delivers an informative assessment on the current state of global credit markets

President Trump’s bashing of the Federal Reserve has continued unabated, he just can’t help himself, continuing to snipe at every opportunity. In August, after the Federal Reserve produced an ‘insurance’ cut of just one quarter of a percent in rates, rather than the larger cut that he thought he had bullied them into, he slapped further tariffs on the remaining $300bn of Chinese imports, apparently in a fit of pique, causing yet more market consternation. The President’s re-election polling took a hit and he has subsequently delayed these measures. The impact of the ‘Trade War’ has begun to be felt directly by US producers, farmers in particular, exports of corn and soy to China have collapsed. A concern that does not appear to have been thought through is that as Chinese exports to the US reduce, they won’t have the same surplus levels of US dollars swilling around that they are used to parking in... US Treasuries (US Government debt).

Despite movements in yields pricing-in a difficult outlook, recession in the US is not assured and the macro outlook is not as dire as some would predict. In the light of Central Bank purchases of government debt, taking too many cues from the shape of yield curves seems incorrect. Credit spreads do not reflect a cautious outlook either, they continue to trade close to their narrowest premiums to government yields. Quite possibly, markets got ahead of themselves over the summer from an interest rate perspective, aided by thin holiday period liquidity and investors moving to ever longer dated bonds. This embraces a level of potential risk and volatility that the underlying client/investor base will not be expecting. There was some discussion about whether the Federal Reserve might issue 100-year bonds, not a great investment (unless you are the issuer/borrower). This, rather neatly, coincided with a regular Argentinian blow-up, halving the value of their 100-year bond, which was issued in 2017 on a 7.9% yield to maturity at 90c, it is now trading at 45c.

The Bank of England owns a third of all Gilts through its own asset purchase programme, so, again, it is hard to ascribe too much validity to the shape of our yield curve. Governor Carney continues to rule out negative rates and has a difficult path to tread with our own ‘special’ situation. Gilts do remain potentially vulnerable to foreign selling as around 28% of the stock of Gilts is held by foreign investors. BoE Deputy Governor Dave Ramsden stated that a resolution to our daunting political problem, whether by the Guy Fawkes deadline or not, would open the door to interest rate hikes. As Gilt yields rose again in late September, the ten-year yield more than doubled from its (possible) inflection low point of 33bp (0.33%), the duration risk embraced by some over the summer came home to roost, the fundamental risk inherent in low coupon long dated bonds has not changed. A second blow to the Gilt market was the Chancellor’s decision to accelerate the process of reforming inflation indices to bring the Retail Price Index (RPI) into line with the Consumer Price Index (CPI) by 2030. Index-linked gilts due to mature after this date fell sharply, with thev2068 issue down 10%, over 50 points of capital, in a straight line.

The Federal Reserve delivered a second ‘hawkish’ cut in rates in September. Since the FOMC remains sharply divided over the necessity and depth of cuts it might be fair to assume that President Trump’s bullying tweets were the casting vote. “Boneheads” and “Jay Powell and the Federal Reserve fail again, no guts”, is the quality of his view on monetary policy. The President’s comment that Fed Chairman Powell’s job “is safe” possibly reveals that he is unaware that he does not actually have the power to sack him.

Several factors converged in the US overnight money market prompting ‘repo’ rates (sorry) to spike five-fold to near 10%. It was evident that the Fed was not in control for a while, until they implemented a $75bn per day reverse repo facility until mid- October. This has restored order for the moment, but with two week repos doubly oversubscribed, the calm is uneasy. US Treasury volatility is at a four-year high and it remains necessary for the Fed to provide liquidity through repos. Their overnight repo facility has now been extended to at least November 4th and eight term repo facilities are also being put in place. There are expectations that at their next meeting, the Federal Reserve will announce that they will recommence expanding their balance sheet, but not necessarily label it as quantitative easing (QE). There is also widespread concern that the Fed has been politicised by Trump pressure, although they assure this is not the case. Thankfully, one or two members of the FOMC remain vocal in contradicting some of the President’s more random and absurd claims and requests.

Nothing has blown the primary market, where companies and governments borrow new money, off course however, and records continue to be broken as we cruised with ease through FY18 total issuance levels across all currencies: €391bn and £37.2bn over the year to end-September, with one week alone seeing $74bn in new issues. We are beginning to see some price discipline from investors and issue sizes at the final price have continued to trend lower down to 1.5-2X from 2-5X previously, i.e. people are pulling orders if deals get too expensive. A Senior Non-Preferred £200mn issue from Metrobank failed, despite offering 7.5%, serving to illustrate that some investors remember that credit risk does still exist, the existing Metro 5.5% issue fell sharply. September was the busiest month ever for issuance. Some has been attractive but others have been hard to summon up much enthusiasm for, e.g. MassMutual, a strong credit, came to the sterling market paying investors 1.375% for the privilege of lending them funds for seven years. Enel also came with a deal offering coupons linked to ESG targets, a first. Metro Bank tried again after their failed issue with another Senior Non-Preferred deal that did succeed, but this time carried a coupon of 9.5%. Bank of Ireland, who had quietly pulled a subordinated deal in September to “ensure successful execution for both the issuer and investors” also returned successfully, but also had to pay a higher coupon. Credit spreads have remained relatively stable over the quarter, not far off the tights for the year, remarkable in the face of widespread uncertainty.

Important information

The above originally featured in our Autumn 2019 Private Client Quarterly Review so is for information purposes only and does not constitute advice or a personal recommendation. The value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment.  You should also be aware that past performance may not be a reliable guide to future performance.

October 2019

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