On one hand, credit investors have never had it better with IG credit spread at record tights and junk bond yields sliding to 3 year lows
On the other, and this is linked to the above, they have never been more nervous, and as the latest Bank of America credit investor survey shows, more worried about the Fed in general, and "Quantitative Failure" in particular.
But why, if as so many claim, the Fed has nothing to do with the the return of risk assets? Ignore that, it's rhetorical.
As BofA's Barnaby Martin writes, August’s survey shows a marked change in the Wall of Worry, in which "Quantitative Failure" has now emerged as investors’ top concern (23%), up materially from June’s reading (6%). The reason for the sudden spike in central bank fears is that Investors say that a backdrop of the ECB ending QE next year, while inflation remains sub-par, has the potential to rattle the market’s confidence.
The sudden fear about "QF", or major policy error, means that the recent biggest worry, “Bubbles in credit” has been downgraded to second biggest concern (down from 33% to 21%) while those worrying about “yields rising” increases slightly (from 12% to 14%).
The chart above shows that at the top of the Wall of Worry for both high grade and high yield investors are:
- “Quantitative Failure”, “bubbles in credit” and “rising yields”
- Interestingly, almost no investor worries now about “populism” or “low liquidity”
- Bubbles in credit still features among the top worries, but is well down from June’s reading (in high-grade it has fallen from 33% to 21%)
Looking at the menu of possible ECB actions, around 30% of high-grade investors say it will be a policy mistake if the ECB raises depo rates to 1% over the next few years. 20% say it will be a policy mistake if rates are raised to 50bp and 11% say a policy mistake will happen if depo rates are raised to just zero. Thus, BofA notes that credit markets remain highly sensitive to expectations about ECB rate hikes going forward (BofAML base case is for first ECB rate hike in Spring ’19). The chart below is a reminder, however, that it is the level of rates vol (not rate level) that has been key for credit spreads over the last decade.
Curiously, many of these adverse sentiments about central banks' screwing up were first observed, in more diplomatic language of course, by the TBAC's latest refunding presentation, in which the most important advisory committee in the US laid out the following three "non-linear risks" that emerge from central bank normalization
- Risk premium compression. Central bank balance sheet expansion, declining bond risk premium, and lower yields induced rising investor bond demand and tighter credit spreads. Corporates filled the demand gap with a surge in borrowing used for equity buybacks. Pure financial engineering.
- Risk Premium decompression, accelerators: Small increases in yields can potentially lead to large changes in risk premium. Credit is the key transmission. Pro-cyclical behavior of investors who ‘piggy backed’ central bank purchases and ECB tapering are possible accelerators to the rise in US risk premium in a tail risk event.
- Let markets clear. A downside risk in a stress scenario is a meaningful decline in risk assets. But it isn’t systemic. Banks and households have not leveraged to higher asset prices. It is a financial engineering shock.
The TBAC even laid out the possible sequence of adverse events, when in a slide it explained how a "stress scenario" could play out: the "amplification from normalization could possibly come from wider credit spreads and be transmitted to equity buybacks and valuations." In other words, higher yields, higher credit risk premium, higher volatility, lower risk prices, market crash.
The BofA survey provides some more context to the TBAC concerns, because as Barnaby Martin explains, "for the majority of IG investors (36%), the “game changer” for the current bullish credit cycle would be the end of QE buying by the ECB."
Indeed, it is the ECB's QE end, not the balance sheet tapering by the Fed, which is increasingly perceived as the catalyst that can finally "ruin the party."
Away from IG, however, for the majority of HY investors, the key break factor would be a Eurozone growth slowdown and/or a rising possibility of a recession. Ultimately these two concerns are the same: reduced liquidity into a recession, the same event that happened in the summer of 2011, when the ECB hiked rates only to unleash the most acute part of the European sovereign debt crisis, culminating with Mario Draghi's vow in July 2012 to do whatever it takes."
BofA also points out that while many hate tight valuations, few see them as a catalyst for the credit cycle to turn. In other words, absent a catalyst, yields can continue grinding even lower until something snaps.
Finally, any upcoming "quantitative failure", or even simple policy shift would have a just as dire impact on that other potential risk contagion source: emerging markets. As Credit Agricole's Valentin Marinov writes in a note today, the approaching decisions by the ECB and Fed on whether to tighten policy, could heighten risk aversion and drive investors out of emerging-market currencies. Such a move would unravel the profitable developing-nation carry trade, which has gained amid subdued volatility and which has served as a souce of funding for many of the credit (and equity) trades.
The result would be the end of an unusual period for foreign-exchange traders, where volatility in major currencies has exceeded that for emerging markets. Needless to say, the volatility during this period would surge for everyone.
"Higher implied volatility reflects growing uncertainty about the outlook and usually comes hand-in-hand with bouts of risk aversion," Marinov said. "EM volatility could re-couple with G-7 volatility if the event risks in September and October force investors to cut their risk exposure and thus unwind carry trades."
Of course, lurking at the bottom of it all, is the upcoming debt ceiling negotiation in September, which could leave the US government paralyzed, the Treasury in technical default and the market violently "roiling" in the words of SocGen.
In short, the calm before the storm is about to end.