Reading the Cuttlefish Bones

Non domandarci la formula che mondi possa aprirti,

Si qualche storta sillaba e secca come un ramo,

Codesto solo oggi possiamo dirti,

Sio che non siamo, cio cho non vogliamo

Don’t ask us for the phrase that can open worlds,

Just a few garbled syllables, dry like a branch.

This, today, is all that we can tell you:

What we are not, what we do not want.

—Eugenio Montale, Cuttlefish Bones

There is a beautiful and magical quality about credit markets: they tell the truths of history. They discard opinion and enmesh financial phenomena—its landscapes and perceptions in the unbiased way of men laying money on their convictions. Here are deeds which shape history, however fragmented by the future. A bond yield is a more direct way to tell the experienced truth. Financial truth, sadly, tells us nothing about what it is. It is eloquent in telling what is not.

Credit shows our contemporary history to be bifurcated between European and North American IG credit index spreads widening and Japan tightening.

Schauble’s decision to stop playing games with Greece induced a European investment grade spread blow-out in late-June, followed quickly by a major return of carry trades that led to spread tightening once Greek leaders got the message. After this mean-reverting move, you’ve seen investment grade widening in a de-risking move.

Credit in the US has been dominated by the reality of Fed tightening, at least relatively speaking. At the worst a rate hike cycle would imply something like two 25 basis point rises, followed by the Fed staying put for the next couple of years at least. Even though the deteriorating planetary conditions make a rate hike more unlikely, the reality is that no QE makes USD-denominated debt the odd man out. It is natural that we should see spreads move wider relative to the other two.

Now Japan is a contrast. We are seeing USD/JPY and EUR/JPY carry trades unwind a bit to the benefit of home currency debt. Given the unrepentant stimulus that the BoJ promises to deliver, de-risking for retail investors means a rotation from Japanese equities and into bonds. It’s no surprise that Japan IG is catching a bid.

A closer look at Japanese credit shows that IG is coupling to JGBs, shown in the 5Y JGB to IG credit spreads. IG has higher volatility, and a higher spread level, but the co-integration is clear and it makes Japanese IG a risk-off asset. Note also that JGB spreads have been tightening for a while now.

What bears watching is another part of the credit universe, often thought of as risk-solid, if a bit illiquid: Asia ex-Japan. With a clearly slowing Chinese economy, and potentially a bursting Chinese credit bubble, you have seen moderate selling. This could turn into a real rout given the dependence of these names on Chinese demand and levels of indebtedness in Asian credit.

I seeing little reason for this widening to reverse. Without Chinese demand, there is no currency stability, returning EM/developing Asia growth, and no sign of earnings recovery. Year to date, 25 global central banks have cut rates and this creates a very powerful stimulus effect. But the crux is that Asian macro growth and earnings will struggle because they cannot ease sufficiently relative to the Fed, the ECB, and the BoJ.

Given that the Fed isn’t easing, it adds to the USD strength that is negatively correlated to EM and growth, Asia included. The US dollar surge raises risks arising from external debt within EM. Although currency reserves for the vast majority of emerging markets are high relative to short-term external debt, there is plenty of reason for spreads to widen.

It’s never fails. Markets kill and eat their past darlings. It has to be this way: finance wouldn’t move without these cruelties. Montale said it best:

Non mai due volte configure

il tempo in equal modo i grani! E scampo

n’e chi: se accada, insieme alla natura

la nostra fiaba brucera in un lampo.

Time never spills its sand

the same way twice! And there is hope in this:

for, if it happens, not nature alone

but our story too will burn in a flash.


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