admin | October 25, 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.
Across most parts of credit, the value of liquidity seems to be rising. Less liquid investment grade debt has widened to more liquid. Lower-rated CLO debt has widened to higher-rated. ‘B+’ and lower rated loans have widened to ‘BB’ and better rated. And the Fed keeps pouring liquidity into the repo market and the broader financial system, but market rates on fed funds continue to exceed IOER. The market seems to be conserving its liquidity.
Liquidity looks likely to get more valuable at least through the end of the year. Seasonal reductions in trading volume and bank balance sheets should drive up liquidity value, especially since G-SIB capital buffers depend on average and ending balances in the fourth quarter. Drawing down repo activity is one of the easiest ways for G-SIBs to reduce total balance sheet and lower the risk of a higher surcharge.
The Fed’s program of overnight and term repo along with its aggressive purchases of Treasury bills is starting to address the liquidity risk, but seeing fed funds still running above IOER suggests continuing friction in moving cash around the system. Although understanding of these frictions continues to improve, the diagnosis is not complete. It is fair to assume that concerns about liquidity requirements and balance sheet size will slow banks’ ability to pass liquidity into the market efficiently.
Investors sensitive to mark-to-market or anticipating significant need for cash in the fourth quarter have good reason to migrate into the more liquid parts of their preferred markets. Most spread products should keep widening into December. Irregular issuers should widen to regular issuers, smaller issues to larger, complex products to simpler.
For investors with access to cash, the market is starting to offer opportunity. Less liquid but fundamentally good cash flows are widening to more liquid. The work needed to re-underwrite the risk in these cash flows should pay off.
Liquidity often rebounds in the first quarter as banks scale balance sheets back up and other investors consequently have an easier time and incur lower costs for rebalancing portfolios. The cumulative effect of Fed repo and reserve injections stands to make the liquidity pick-up in early 202 especially sharp. Investors able to weather a few months of relative illiquidity can harvest likely gains in the New Year.
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The view in rates
The Fed looks almost certain to cut another 25 bp on October 30 and bring its mid-course correction to a temporary end. The telling part of the upcoming FOMC will likely be in the monetary policy outlook. Rates in the front end of the curve look likely to be pinned down, but the long end of the curve should be sensitive to the Fed view of growth and inflation, including the influences from a slowing global economy.
The view in spreads
Except for the leveraged loan and CLO markets, investment grade and high yield credit continue to tighten. Leveraged loan funds continue to see outflows while high yield funds generally see inflows. Even though less liquid components of each market should widen to more liquid, the liquid parts of credit still have some room to tighten. MBS has lagged credit and should continue to trade at soft spreads largely due to heavy volumes of refinanced loans flowing through the market. MBS spreads should stay soft through the balance of the year and start to tighten thereafter.
The view in credit
Slowing global growth will almost certainly catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.
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