Why do credit spreads matter?

Over the last few weeks, we've seen a tonne of different narratives pop up...

Russia vs Ukraine (no not a European friendly, very much a European UN-friendly)...

The Fed, fedding...

Inflation still ticking higher (STILL TRANSITORY AND I WILL DIE ON THIS HILL)...

European data flattening...

Bear flattener trades being slapped on...

European rate spreads widening...

You get the picture.

There's a lot going on, but there's no real expected follow through to risk!

Well, why?

What people are still not quite getting is that there is a power dynamic going on right now, of expectations vs actual activity.

And even some 'experts' aren't quite getting it...

The Fed may have started tapering, but what truly matters is that there is still a net buy.

And what this means is that the risk premium of buying equities is still quite low...

Or in other words, the hurdle for risk taking is still very low.

And we can even see this decreasing liquidity by looking at the cost to do business in the SP500 E-mini contract, which I'm pretty sure I've shown you before...

It's elevated, but not so bad as one month ago.

This matters.

Liquidity drives the market, and what we are trying to tell you here is that liquidity withdrawal...

IS ALL THAT F*CKING MATTERS!

But this allows us to get into what the title of this piece is about.

It tends to be that bond traders are the smartest in the room.

So you can loosely follow that in the more micro realm of individual companies' bonds, credit traders will tend to reprice according to the market conditions, and perhaps before equities traders perhaps.

A credit spread is the difference in yield of a corporate bond with the same maturity but different quality.

Having a good grasp of what's going on in credit markets is therefore pretty important.

Two easy ways to view the credit situation is by looking at two different ETFs, LQD and HYG.

Right now, we can see that the situation ain't so pretty...

LQD tracks investment grade corporate credit and HYG tracks high yield (pretty much junk - the shitty stuff).

But this doesn't give us a complete picture in my view, since they're simply ETFs.

To really look and see what the situation is, we can take a look at a few other components to define the 'risk level'.

Here's the definition of this indicator...

There is one big flaw here that is yet to be unearthed...

The spread is calculated versus the treasury yield curve...

But US treasury yields are elevated...

See the issue?

No?

Well let me introduce a concept to you, known as Wittgenstein's Ruler.

It's a bit wordy, but let me explain how this relates to what we're chatting about here.

So we know that the spread is measured versus treasury yields...

But treasury yields are currently elevated.

So the indicator is currently not suggesting adequately enough the risk that credit spreads should be showing.

Does that make sense?

Now if we take into account the yield curve, we can perhaps start to see what might happen post hike in March...

Here we have the 2s10s curve, and it's flattening considerably.

If we expect rate hikes to delver risk assets, what mood might this have the market in?

A rush to safety, most notably leading to the 10 year yield pushing lower?

That's my thinking.

What we'll therefore see is the 2s10s spread flattening even more.

And Zoltan Poszar, the famous financial plumbing analyst at Credit Suisse, has similar thoughts...

You can view the whole piece below, but he's essentially arguing that the Fed would like to lower asset prices to get labour supply higher!

  Zoltan Volcker Moment  Zoltan Volcker Moment.pdf 181 KB     

This in turn should prevent a wage price spiral.

Here's the key line.

I mentioned something similar in the Macrodesiac Discord yesterday, in that I was expecting a vol spike.

Zoltan finishes his piece off with this...

If this were to occur, we would 100% see an extreme reaction in corporate credit, purely by way of how it's all benchmarked, but ALSO, because of the overall market condition, which will largely be of greater importance.

Declining treasury yields in a risk-off environment does not have the same effect as declining yields being used to foster a risk asset recovery.

And we can see how high yield credit spreads behaved in 2020 with this in mind.

The reaction, in fact, was rather belated...

And this relationship may go some way to explaining why credit spreads have not yet reacted with the sell off seen in the credit ETFs.

Simply, it's a different dynamic that is reliant on true flight to safety and liquidity withdrawal.

But this is why my focus is on them...

That liquidity withdrawal is coming, and to me, the path is clear (spreads widen and there is severe dislocation).

March seems like a good time for that to occur, but until then, we will see the equities market range in my view, since there is no particular driver that will call an outsized vol explosion (maybe unless the Russia situation escalates, but that seems more like something that will affect European equities - which is why I am short DAX, partly).

Hit me up with any specific questions here!