Carry No More: Credit Evolution and Fragility

So I didn’t post an update on credit leading up to the Fed rate decision, because frankly nothing really mattered without that piece of knowledge in place.

It was kind of a non-event. What I mean is that nothing in credit was really resolved by the Fed decision. It is time to face the fact that the financial universe has changed and a good think is needed to figure out how to make money given the change.

The Fed’s exit from QE implied that the policy of propping up the asset side of the aggregate macro balance sheet was over. The Fed raising of interest rates implies that the liability side of the aggregate macro balance sheet is robust enough to absorb higher cost of funds. This is a positive sign for balance sheets, but doesn’t improve cash flow and P&L. This is a good sign for credit. Credit trades off the balance sheet. Equities trade off P&L. What was wired is that there remains no sign of inflation, leading one to wonder why the raise was needed in the first place. 25 bps isn't going to deflate bubbles.

The power of carry flow is greatly diminished as we approach 2016. There are still places where carry matters, but at the beginning of 2015, you could bank that a move in JPY would spur a local currency EM credit sell-off. Emerging markets have been wrung dry of speculative flows this year. Looks like policy sets USDJPY at 120 give or take for a while and no amount of economic weakness is going to cause that to meaningfully break to the downside. Policy has spot dollar (manifested in DXY) not breaching 100. So much for carry flows in the traditional sense: the commodity price implosion has obscured much of the impact on BRIC credit.

What about fundamentals? The macro of this matter shows the iTraxx Japanese corporates (average maturity around 5 years) trade at 12 month wides to 5Y JGBs.

In North America, iBoxx IG cash bond asset swaps moved from 65 to 83 basis points in the past year, which is a decent move that could mean moderate pain, but IG spreads over comparable high yield shows a broad and definite risk-off posture. Looking forward, retail sales are going to leave something to be desired, but this was telegraphed to markets back in November. The Fed actually gave a boost to confidence by raising rates, but taking that view could end up being a swim against the tide.

We have thin credit markets that are hugely co-integrated. The implication is that real money is happy to park money and collect premium in CDS indices, and any divergence in the majors is met with buying the spread. We have in effect big real money flows, not knowing what to do and creating something that looks like a credit “arb”. It is not an arbitrage. It is a sign of extreme fragility. If levered players get caught wrong-footed here, this could turn into an avalanche easily enough.

The Fed is confident in corporate balance sheets. The asset side in general no longer needs to be propped up, so companies with decent cash position and modest operating leverage can handle marginally higher funding cost. Names meeting these conditions are solid. Cash flow growth is possible, but is not prevalent across names and sectors.

As long as there is no inflation, there is a value in core bonds—treasuries, bunds, JGBs. As long as there is no inflation, when the treasury curve sells off, risky credit as a generalization will sell-off more. As long as there is no inflation, the long end of the treasury curve will have a proper bid when expectations expect recession.

Tail risk? Inflation.


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