The Big Idea
This time is (not) different
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.
Spreads on risk assets keep tightening. Deal flow across corporate and structured credit keeps rising. The tone in conversations with investors is more bullish than not. It is tempting to see this as an extraordinary outcome in the aftermath of Fed tightening. But the broad pattern of spreads in risk assets through the last three tightening cycles have been roughly the same. Markets like tightening when it comes to an end.
Three cycles of Fed tightening make a thin foundation for any strong conclusions, but a least two features stand out in the hiking cycles this century under a Fed that has been far more transparent than its predecessors:
- Spreads on risk asset start and finish a hiking cycle in roughly the same place, maybe even biased to finish a few basis points tighter, and
- Spreads tighten after the last hike, or at least when the risk of further hikes ends
Cycle #1: 2004-2007
From the beginning to the end of Fed hiking from June 2004 to September 2007, spreads on risk assets started and finished in the same place. The option-adjusted spread on the Bloomberg US Aggregate fixed income index started on the day of the first hike at 48 bp and ended on the day of the last hike at 48 bp (Exhibit 1). In between, risk assets generally traded tighter. And after the last hike, risk assets traded tighter again for another six months until a new set of risks started to emerge—mortgage loans that started to default after just a few payments, declining home prices, the failure of New Century and other Alt-A mortgage originators in March 2007, the collapse of Bear Stearns hedge funds in the summer of 2007 and stress in commercial paper markets.
Exhibit 1: Spreads on risk assets during the 2004-2007 Fed hikes
Source: Bloomberg, Santander US Capital Markets
Cycle #2: 2015-2019
As the Fed hiked from December 2015 to December 2018, spreads on risk assets moved only slightly tighter. The OAS on the Bloomberg Aggregate started at 58 bp and finished at 51 bp (Exhibit 2). In between the first and last hike, spreads again generally traded tighter, widening only with the last two moves. And after the last hike, spreads again tightened as the Fed kept policy rates steady.
Exhibit 2: Spreads on risk assets during the 2015-2019 Fed hikes
Source: Bloomberg, Santander US Capital Markets
Cycle #3: 2022-today
The current cycle again shows spreads on risk assets roughly unchanged from start to finish. From the first hike in March 2022 to the last in July 2023, the OAS on the Bloomberg US Aggregate moved from 50 bp to 48 bp (Exhibit 3). Spreads traded wider more often than tighter while the Fed hikes. But since the Fed has finished—or more specifically, since the Fed in November clearly pivoted away from hiking further—spreads have traded tighter.
Exhibit 3: Spreads on risk assets during the 2022-2023 Fed hikes
Source: Bloomberg, Santander US Capital Markets
Reading history
There’s plenty of room for interpretation of these cycles. QT and changes in bank capital and liquidity rules have been in play through parts of these cycles. Interpretation also gets clouded by the changing composition of risk in the aggregate index. The mix of Treasury, MBS and corporate debt changes. The convexity of MBS shifts. The rating mix of outstanding corporate debt evolves. That even complicates comparison of spreads on the index over time. Of course, over the limited span of a hiking cycle those changes may be small.
The most meaningful conclusion may be that the tightening of spreads since November just means the current cycle is at least directionally just like its immediate predecessors. History repeats itself. The market sees the Fed as temporarily making policy restrictive but anticipates the next move as easing and broadly better for growth and credit. Spreads tighten in anticipation until new information suggests otherwise. Given the strength of most household and corporate balance sheets and the capital and liquidity in the financial sector, a domestic shift in risk trajectory looks unlikely. A three-legged history lesson says spreads can go tighter.
* * *
The view in rates
Fed funds futures for a third week price roughly 34 bp of easing this year as of the Friday close. The market-implied probability of cuts at different meetings also are roughly unchanged. The market sees a 50% chance of September and a 60% chance of December. It’s still all about sticky inflation. In the aftermath of the last FOMC, implied rate volatility continues to drop and is near the lowest level of the year.
Other key market levels:
- Fed RRP balances closed Friday at $449 billion, down $37 billion in the last week. RRP balances have bounced between $400 billion and $500 billion since the start of March. That range has held despite yields on most Treasury bills running well above the RRP’s 5.30% rate.
- Setting on 3-month term SOFR closed Friday at 533 bp, unchanged on the week
- Further out the curve, the 2-year note closed Friday near 4.82%, down 5 bp this week. The 10-year note closed at 4.42%, down 8 bp this week.
- The Treasury yield curve closed Friday afternoon with 2s10s at -40, flatter by 3 bp this week. The 5s30s closed Friday at 11 bp, flatter by 2 bp over the same period.
- Breakeven 10-year inflation traded Friday at 233 bp, down 3 bp this week. The 10-year real rate finished the week at 210 bp, down 5 bp this week.
The view in spreads
Falling implied volatility should create more room for spreads in all risk assets to tighten a little further. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former often funded with annuities and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.
The Bloomberg US investment grade corporate bond index OAS closed Friday at 87 bp, unchanged this week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 140 bp, tighter by 2 bp this week. Par 30-year MBS TOAS closed Friday at 35 bp, joining the parade of metrics unchanged tighter by 8 bp this week. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp in OAS, so widening toward fair value looks reasonable.
The view in credit
Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.
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