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Rates, spreads, credit
admin | July 19, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Lower rates, tighter spreads, improving conditions for credit. That clearly seems to be the setting the Fed hopes to create. And the market seems inclined to follow the Fed’s lead.
The view in rates
Fed Chair Powell this month gave the market plenty of reasons to expect the US 10-year yield to continue ranging between 2.0% and 2.2%. He has likely set the range for longer rates until September and possibly through the end of the year. But the bias over a longer horizon should be toward higher levels. Shorter rates have priced in a steadily lower path for Fed funds through 2020. As effective fed funds drop lower, longer rates should hold steady and eventually start to rise toward the Fed’s neutral level rates of around 2.5%. It’s a recipe for a steeper curve.
Even though implied volatility dropped as expected after the G20, the underlying trade dispute remains only slightly less predictable than before. Implied volatility, at least as marked by the MOVE index, remains high relative to most levels of the last two years. The US and China are talking, which helps, but fundamental differences in approach to trade seem as significant as ever. Prospects of US-China trade war should keep volatility elevated, but the Fed seems inclined to counter the possible worst effects. Still, convexity still looks likely to perform well into 2020.
The view in spreads
Although spreads in credit and MBS historically have widened as the Fed starts to ease—the case in the early 2000s and in 2008—this time looks likely to be different. Recession does not look imminent, which was the case in 2001 and 2008, although market consensus sees growth today slowing into the neighborhood of 2%. Credit already seems priced for slowing growth, so lower fed funds and improving market liquidity should help credit fundamentals and improve demand for spread. Easier financial conditions should also lower the returns to liquidity and, consequently, improve relative returns on less liquid assets.
The view in credit
Slowing growth looks almost certain to catch some weaker or more leveraged credits offside. The recent abrupt repricing of a $693 million leveraged loan to Clover Technologies has spurred a flurry of due diligence on other loans or exposures that might be vulnerable. It’s early, but so far the repricing looks idiosyncratic and not a sign of a broader problem. The Fed seems sensitive to the $10 trillion in outstanding corporate debt securities and loans, equivalent to roughly 50% of US GDP. Lower rates and better liquidity should give good corporate management opportunity to strengthen balance sheets.
As for household balance sheets, the generally good news there keeps improving. The Mortgage Bankers Association index of refinancing activity lately has jumped back to levels last seen in 2016 when 10-year rates last stood at 2% or below. That activity will continue cutting household debt service, which already was at historic lows. It should also give some support to home prices, which should help homeowners continue building their equity. Of the major balance sheets in the economy—government, corporations, households and banking—households may be the strongest.
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