Main Thunderstorms and CDX Changes of Season: Credit Relative Value Round-Up

The question on everyone’s mind is whether the events of the last few days represents a passing thunderstorm or heralds a change of season in risk. The evidence inclines toward the latter. Which is to say: the Fed taking away the punchbowl, and assets are at least now ready to reprice risk. There are areas (equities) where this repricing is not finished by a long shot and it unclear to what extent this re-pricing is over in credit.

Just because we are facing a change in risk-appetite or, equivalently, a change in volatility regime in various asset classes, it doesn’t mean that anyone should be preparing for systemic meltdown scenarios. Sad that I have to say this.

What you should expect instead is that finally HG debt is going to focus on address the impact of commodity prices on its balance sheet, slow issuance, and we will see its 2015-to-date underperformance compared to equities finally diminish.

Credit clearly realized the game had to end starting with the “taper tantrum” in the summer of 2013, and the 2x25 basis point hikes expected in late 2015 and early 2016 will impact leverage to some degree just because credit is by its nature (size and volatility character) more amenable to leverage than equities. This impact raises leveraging costs and thus induces selling. Clearly equities haven’t care all that much.

Here’s the problem. Credit has been distracted from funding cost concerns because of commodity price collapses, first in EM high yield, spreading to North American high yield and now encompassing high grade as well. So in effect it is about taking away the punchbowl, but the channel is through a resulting spike in the dollar kicking the snot out of commodity prices and impairing balance sheets in the process.

Many factors impacting the immediate sell-off have moderated. USDJPY collapsed over August, nearly hit 118.40 before bouncing. This is a HUGE relief for carry. The Main and especially CDX tightened yesterday. This is a HUGE relief for credit liquidity.

But the extent of the sell-off was striking in Europe, North America, and Japan. At the same time, these indices tell a lot about who is expected to continue spiking the punchbowl. That would be the BOJ and the ECB. The Fed? Not so much, especially since mid-July and Greece intransigence and incompetence stopped harshing the European mellow.

Looking a bit deeper, you see something very interesting in Japanese credit: 5Y protection on JGBs has sold hard. I’m thinking that a sub-35 basis spread or the corresponding cash yield level is a mean-reversion trigger. Back in April you saw bottoming at the same level and money doesn’t like it. Japanese corporates, moved in lock-step.

In the US, credit spread widening has been more prominent in the cash market and CDS. This is because high grade cash is due to greater exposure to commodities and heavy issuance this year. High yield is also heavily weighted with energy names, but the issuance is much lighter than in the past. So HY and SPY are now performing at parity, compared to HG underperformance compared to equities even after the sell-off.

So what’s next? In the US/North America, the time-honored lessening bond issuance as companies realize that energy price collapses are no mere blip. Then the focus turns to addressing balance sheet and cash flow impairments in both HY and HG. For HY there will be some jumps to default and equities will catch-down to this reality.

In Europe , where energy name carry less weight and the ECB has no intention of taking away the puchbowl to mitigate anothe possible Greek escapade, risk appetite in credit will be little changed.


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