Church House CEO Jeremy Wharton shares his expert analysis of Credit Markets as part of latest Quarterly Review
June rounded off a brutal first half for risk assets (I’ll let James give you the records but ‘nowhere to hide’ was a popular refrain), with 2022 turning into everything that 2021 wasn’t. Credit spreads traded in a tight range throughout last year, in contrast we close out the first half of 2022 at the widest levels seen since March 2020, before Central Bank action stabilised markets.
In turn, this has been the most volatile period for credit seen since the ‘PIIGS’ (Portugal, Italy, Ireland, Greece and Spain as a reminder) blew up in 2011. Developed country Sovereign yields have reacted to a different kind of Central Bank action as quantitative easing winds down and rates are hiked in the face of the kind of inflation reports not seen for many decades. Stagflation is a word that many analysts are keen to use and there seem to be daily revisions of growth forecasts.
Jerome (Jay) Powell was nominated by President Biden for a second term, which was confirmed by the Senate Banking Committee with only one dissenting vote. The Federal Reserve is concerned that inflation will become entrenched and are now leading the charge, by the time this is published we are likely to have seen another 75bp hike in rates with plenty more to come, judging by the overt hawkish language of most voting members of the FOMC and a continuing tight labour market. Put this in the context of the fact that they only started hiking in March and no wonder that risk assets have taken fright.
Ten-year US Treasury yields reached just shy of 3.5% in mid-June and for many this was the forecast terminal rate, the potential peak in this hiking cycle. As fears of these actions and the continued removal of monetary stimulus provoked worries of a sharp slowdown, or even a mild recession, yields fell back again to 2.80%. In contrast, the Peoples Bank of China cut rates as their zero covid lockdown policy weighed on activity and attempting to support the stuttering Chinese property market
The ECB on the other hand, is still talking but not yet doing, although their language is also becoming more aggressive and money markets are indicating two half-point rate hikes by October. They haven’t seen the same levels of wage inflation as elsewhere but they continue to have a much finer line to tread, not only because of the usual and historical disparity in the size and durability of their member’s economies, but also because the Ukraine conflict has laid bare the reliance on external sources of energy. We are not yet in the territory of that sovereign debt crisis of 2011, but spreads have gapped wider.
The ten-year German Bund, trading at 0% in March moved as high as 1.75% (a fall of 16% for the price of the bond), while the spread between Italian and German yields jumped from 1.5% to 2.4%. The ECB has responded with the intention to implement an as yet unspecified spread cap (control) facility.
The ECB also have their ‘Next Generation’ fund already in place, originally to counter the fallout from COVID but now, potentially, could be used to alleviate the effect of price pressures across the area. The euro continues to edge closer to parity with the US dollar.
The Bank of England continues on its rather less aggressive rate-hiking path as they agonise over cost-of-living pressures, and now the Bank has a political crisis to worry about too. Thankfully, so far, this is seen as a sideshow to how the actual UK economy is performing, but sterling gives us plenty of pointers as it weakens further (the worst drop against the US dollar since 2009) and the Gilt yield curve thinks they need to be more aggressive as short end rates rose sharply (bear flattening). The ten-year Gilt yield reached 2.5% (also regarded by some as the terminal rate) but then retreated to 2.25% by the end of the quarter.
The reality of inflation printing at 9.1% means that the Bank has to keep on its path and the saving grace of record low unemployment and strong job numbers overall remains inconsistent with maintaining rates at 1.25%. The Bank’s approval rating fell to an all-time low with just 25% of respondents saying that they were satisfied with their performance, the lowest since the survey was introduced in 1999. Coupled with record public inflation expectations, they must be feeling bruised.
Underlying credit market activity however does remain relatively healthy. Primary market issuance levels are markedly down, but some Investment Grade issuers are managing to succeed, albeit only at levels that correctly compensate investors. All-in yields available, due to sovereign yield rises and credit spreads widening, are at levels not seen for years - a complete turnaround from this time last year.
For the moment, the days of little or no new issue premium are over. The primary market remains effectively closed for High Yield issuers, ‘the end of easy money’ as one commentator put it, although one or two have managed to issue, at a price. Covid-affected Carnival Corp (cruise ships) issued eight-year bonds on a 10.5% yield compared to paying just 6% seven months ago (both rolling-over maturing debt).
Emerging market (EM) issuers are unable to refinance either and having previously issued debt in dollars, the value of their debts increases as US dollar strength sweeps the globe, reminiscent of a certain period back in the 1990’s. EM debt investors tempted to invest in other peripheral sovereigns paid the price as Russia’s grace period to pay liabilities in the correct currency expired and they defaulted on their foreign currency debt for the first time since 1918.
The full Quarterly Review is available here.
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