Financial market stress is not abating. On the contrary, central banks openly admit that their inflation forecasting capability has been short of the mark. Even if this is the case and no dynamic stochastic general equilibrium (DSGE) model has been of any help, central banks should improve and work on their guidance with respect to terminal policy rates. The DSGE models essentially are built on the interaction between demand, supply functions with the monetary policy reaction function. These DSGE models have driven policy making over the past decades. They rely on a set of assumptions related to perfect competition, instant and comprehensive price adjustments, rational expectations, lack of information asymmetry and uniform behaviour of firms and households. It becomes obvious that the pandemic and geopolitical stress present today do not make for a good fit with such models. So, central banks have decided to stick to a ‘simple’ response: “We only focus on fighting inflation and anchoring inflation expectations. Increasing policy rates will be the blunt instrument of choice.”
Unfortunately, such communication strategies increase uncertainty. It is supporting the ‘moving goalposts’ narrative I commented on some weeks ago. As inflation prints in the EU and the US held above the 8%+ digit central banks might have to go beyond the central tendency of the highs in policy rates as priced by markets. That would see US FED fund rates touch 4% (or higher) or ECB policy rates reach 2.5% (or higher). Demand across goods and services would be curtailed aggressively. That would break the back of inflation.
Under such a scenario, expect German and US yield curves to invert aggressively. The US yield curve inversion that became visible over the past week speaks volumes: 5-year Treasury rates closed the week at 3.25%, 7-year Treasuries at 3.23% and 10-year Treasuries at 3.15%. The market is taking aim at higher policy rate goalposts…
At such moments, it is important to look at an asset class that sits at the crossroads: high yield credit. High yield corporate bonds hold up between the equity asset class and investment grade corporate bonds. Historically, the return correlation with equity markets is positive and fluctuates around +0.5. When equities declined by 10%, one could expect high yield to drop by about 5% or vice versa. During most crisis moments over the past decade, the return correlation versus risk-free government bonds was slightly negative. Against investment grade credit, the correlation is positive but well below the equity correlation.
Now, a peculiar episode unfolded in rate and credit markets over the summer of 2021. A closer look at performances since then informs us that longer-term correlations did not rhyme with history and did not repeat. Indeed, what kicked off the big market reset was not a cyclical growth scare. It was inflation. A worry that has never been much debated or feared over the past 30 years.
The inflation beast impacted EMU government bond performances most. From August 6 2021, with 10-year German bund rates at -0.50%, till today, EMU government bonds returns have retreated by -15.1%. European investment grade corporate bonds show -12.8%, whereas high yield fell back a reasonable -10.4%. Eurozone equities retrace -12.7% and Europe-wide equities resist well at -6.7%. Market turmoil is fed by rising rates. The higher and unpleasant rate volatility has pushed credit risk premia higher as the fear of a hard economic landing creeps into the mindset of market participants. Sell first, think later is the adage today.
Whether we enter a technical recession or not, the rate adjustment has pushed European high yield credit into a more-than-fair value area. The asset class, even adjusting for the lesser liquidity conditions experienced at this juncture, offers a yield of around 6.00%. The asset class has seen its credit spread more than double over the past year. At 4.85% of 485bp, it sits right in between a 400bp to 600bp range that is commensurate with stressed market conditions brought about by high uncertainty on future growth, as was the case for example in early 2016. Chinese growth uncertainty was the culprit back then. Yet, today we encounter a mix of persistent inflation overshoot without noticeable real danger that unemployment spikes as a result of a cyclical growth downturn.
Again, financial markets adjust to a reality that, who would ever have thought or imagined, might send us back to a pre-GFC reality, where markets offered fairly correct long-term return expectations across asset classes.
Central banks are eager to adjust quickly. The fast and furious hiking cycle by the FED and the ECB is getting priced today.
An interesting subcomponent of the high yield market is represented by deeply subordinated bank fixed income securities. These bonds labelled as AT1 (Additional Tier 1 bank credit) act as core capital to banks. The moment the bank would not be able to honour regulatory capitalisation minima, these bonds would stop paying coupons at best or be converted into equity at worst. We remember the painful market sell-off of March 2020. Well, the EUR AT1 subsector has repriced in line with valuations seen back then with yields on offer between 6% and 6.5% to first call date. These levels align with the expected equity dividend yield for European banks: a rare signal. Typically, these kinds of subordinated bonds run into technical issues such as forced liquidation when moments of panic or capitulation hit markets. At that moment, true value resurfaces. Markets, also in equity, reach a bottoming phase. However, it can be difficult, or even impossible, to assess when such moments arrive. Vigilance is key.
In the meantime, the European high yield universe, with a buffer of close to 5% in credit risk premium, can stomach a cumulative implied default cycle of around 32% over the next 5 years (i.e., on average more than 6% defaults a year). The average default cycle over the past 30 years has been 15%. The worst realised 5-year cumulative default cycle sits at 30%. Actual expected defaults over the next 12 months are below 2%.
The much-debated high yield maturity wall is not the main worry. Refinancing needs for high yield companies over 2022 are low. Hence, current issuance is low. Expect new issuance of quality HY companies to be welcomed with interest as markets reopen after the summer.
It is clear that financial conditions are tightening quickly. The fast and furious reset is puzzling many market participants. However, some barometers work better than others. Closely tracking the high yield market can tell and teach you a great deal about how far we repriced across asset classes.
