Global credit market flashes early warning
THE credit markets have sharp antennae. They issued early warning alerts four to eight weeks before each episode of stress over the last 20 years, although with several false alarms along the way.
The shake-out in the US junk bond market last week had an ominous feel for traders and may finally mark the top of the post-Lehman boom in corporate credit. The exuberant reach for yield is nearing its limits. “It is a sober moment. People are suddenly aware that central banks are turning serious and are not going to keep creating stimulus ad infinitum,” said Marc Ostwald from ADM.
The metric watched by markets – the Bank of America Merrill Lynch high yield option-adjusted spread – has jumped 40 basis points to 3.8pc over the past two weeks. Blackrock’s iShares HYG fund, the biggest exchange traded fund (ETF) for junk debt, fell to a sevenmonth low on Friday. The electric power group NRG Energy pulled an $870m bond issue citing “market conditions”.
These moves are not large by past standards but they bear watching. “This sell-off is not isolated to the US. My intuition is that something broader is happening,” said Peter Schaffrik from RBC. The iTraxx Crossover index measuring bond risk in Europe jumped 25 basis points to 248 over five trading sessions.
Michael Hartnett from Bank of America advises clients to keep buying the dips for now, describing this as a “dress rehearsal” for a big correction in global asset prices next year when the world passes the point of peak monetary stimulus. His “Icarus Trade” lives on. The bank’s “Bull & Bear” indicator of optimism is 7.2, still short of a screaming sell signal above 8.0.
Institutional investors are holding back 4.7pc in cash and are not yet fully committed. Keep your nerve until it falls to 4.2pc, says Mr Hartnett.
The initial trigger for the latest jitters was a shift at the Bank of Japan, which is having second thoughts about purchasing $4.5bn (£3.4bn) a month of ETFs under its quantitative easing programme.
The BoJ’s statement said “extreme measures” aimed at boosting inflation endanger financial stability and could do more harm than good.
The cautionary words comes after several weeks of reduced purchases by the BoJ. The warning hammered the Nikkei index, although it is still up 18pc since August. The BoJ owns 72pc of Japanese ETF’s and is crowding out the public share float of substantial companies such as Fast Retailing, TDK, and Trend Micro.
A parallel shift is under way at the European Central Bank where several governors suggested a total halt to QE as soon as next September. The ECB has
already announced that it will halve bond purchases from €60bn to €30bn a month at the start of 2018. Ireland’s central bank chief Philip Lane said there are signs that inflation is “snapping back” and warned that the ECB may have to tighten sooner than people expect.
The coup de grace came from Washington where the Senate Republicans rejected the House bill on tax reform, demanding a delay in corporation tax cuts until 2019. Gridlock on Capitol Hill has chilled animal spirits, so far mainly in the credit markets. The S&P 500 equity in- dex is less than 1pc from its peak.
The plan to cut corporation tax from 35pc to 20pc has been a crucial prop for Wall Street. S&P calculates that a 1 percentage point fall in business taxes adds 1.2pc to equity prices, ceteris paribus. The open question is to what degree investors have pocketed the tax cuts in advance, leaving no margin for disappointment. The S&P 500 is trading at a forward price-to-earnings ratio of 18.3pc, the highest since the dotcom bubble. What events in Asia, Europe, and the US all have in common is a hint that governments can no longer be relied on to keep propping up asset markets.
Serious sell-offs in high-yield credit typically see spikes of at least 120 basis points, three times last week’s move. But nobody knows where the pain threshold lies in the post-QE world. The structure of global debt has been distorted by emergency policies. The interest rates of the G4 central banks are minus 1.5pc in real terms. The quartet has purchased $11 trillion of assets since 2009.
Suki Mann from Credit Market Daily said the ECB has been soaking up investment-grade bonds, pushing buyers into junk debt. “People are buying anything they can still find with yield and nobody wants to get left behind. Money is still pouring in. We’ve smashed all previous records this year for issuance in Europe,” he said. “Actually it is not even high-yield any more because there is no yield at all. We have never been in a situation like this before and at some point there will be crisis,” he said.
The bubble has been astonishing. Yields on the ICE Bank of America Merrill Lynch euro index for junk debt dropped from 6.4pc in early 2016 to 2pc just before the latest sell-off. This is lower than yields on 10-year US Treasuries, usually regarded as the benchmark safe-haven asset for the world. “There is no doubt that it is a massive bubble, and it is only a question of when it will burst,” said Chris Wang from Runnymede Capital.
Veterans say the market moves over recent days recall the micro-tremors in late 2006: the first nagging concerns about US subprime and a local eruption in Iceland, against a backdrop of eurozone hubris. The party was to run for another half year but the best was over.