The two hallmarks of the 2000-2002 and 2008-2009 financial crisis were: 1) the inversion of the 2-10 year yield curve (I will refer to this as “the curve” or “the yield curve” for the rest of this article, to the exclusion of other tenors); and 2) the subsequent start of an easing cycle by the Federal Reserve.
The two events are closely tied to each other, but not for the reasons one might think.
Let me explain.
Contrary to the common mantra that the inversion of the yield curve is a signal of deteriorating economic conditions and an impending recession, the inversions preceding the last two financial meltdowns were the primary cause of the financial collapses, which in turn brought about deep recessions.
Without getting too wonky, here is how that dynamic worked.
The yield curve inversion causes funds which buy credit instruments using leverage (corporate bonds, and derivatives such as structured products) to reel in their purchases. Without a positively sloped curve, the appeal of “carrying” long dated assets (7 to 10 years) with shorter dated financing (typically 2 years) disappears.
As demand for credit wanes, risk spreads widen, prices of existing credits fall, and the most highly leveraged funds start getting hit with margin calls. Margin calls on credit are totally different animals from margin calls on stocks, where you can push a button and a market-maker will lift your stock in a nano-second (losses notwithstanding). When credit is subject to forced sales it goes “bids wanted” and, for the most part, bids don’t show up until so much lower, that a new round of forced selling kicks in.
To add insult to the spiral, allocations of fresh cash to credit funds dry-up and even the refinancing of healthy credits becomes a challenge; that leads to defaults, more spreads widening, and…rinse and repeat. Under these conditions, our finance-driven economy stands no chance to survive, and, in short order, the credit crunch spills into the “real” economy.
Enter the Federal Reserve. After a tightening cycle which often contributes to the inversion of the yield curve, and after enough noise is generated about the risks of a recession, the Federal Reserve (Fed) playbook calls for the start of an easing cycle. From the standpoint of its mandate, that’s what the Fed is supposed to do to stabilize the economy. Unfortunately, lower rates do little if anything (or at least did nothing during the 12-18 months preceding the last two credit meltdowns) to stabilize the credit markets. 200bps lower in the base rate over 12-18 months is not going to repair the double-digit losses hitting leveraged funds, let alone allow them to flip from being forced-sellers of bonds to being buyers of credit.
And in a twisted and ultimately catastrophic way, lower Fed rates contribute to heightened speculation in the equity markets, which are conditioned not to “Fight The Fed”.
It is not a coincidence that the most explosive legs of the late 1990s and 2003-2008 equity bull markets occurred after the Federal Reserve flipped from tightening to easing, despite the fact that, simultaneously, corporate credit was melting down: by the time equity players lose their fixation with the siren song of lower Fed rates, the corporate credit market has pulled the rug from under them, and meltdowns like ’00-’01 and ’08-’09 are all but inevitable.
Which brings me to where we are today. After a couple of years of tightening (longer if one considers the removal of quantitative easing as part of the tightening cycle) Fed Fund futures are showing a 50% chance that the Fed will cut rates at the July meeting. If the Fed does ease, it would trigger one of the two signals of eventual financial doom. However, what makes it so tricky this time around is that the easing cycle would start without a prior inversion of the yield curve.
Where does that leave the markets? The answer is less than clear, and the secondary data points we can look at for guidance tend to conflict as well. Here is a laundry list of items that both bulls and bears can point to:
• So far corporate credit (especially Investment Grade) is showing no signs of stress. My tally of some of the largest bond sales in January and February of this year (one of the three annual periods when companies raise money en-masse) shows that buyers of those bonds are up an average of 5+ points on price; the same goes for the buyers of the September ’18 bond binge (up ~ 3 points). And even those who bought in Jan-Feb ’18, when risk spreads had tightened to decade-plus lows, are only down less than 2 points. To boil it down to the simplest terms, margin calls don’t happen when the prices of the bonds bought on leverage are above the issuance price. Advantage bulls.
• Year to-date corporate bond issuance remains at a $1.5 trillion annual pace; that’s nearly identical to 2018 and perfectly healthy. As a point of reference, issuance in ’07 and ’08 (after the curve remained inverted for most of 2006) was $1.2 trillion and $940 billion respectively. Advantage bulls. But these issuance levels are significantly below 2016 ($1.7 trillion), and the mind boggling 2017 total of $1.9 trillion. Advantage bears.
• The decrease in bond issuance appears supply-driven (i.e. companies are offering fewer bonds); large bond offerings are regularly oversubscribed multiple times, and the credit market is wide open for financing of M&A deals. Advantage bulls.
• Risk spreads remain historically low in both Investment Grade and High Yield names (Advantage bulls). But the volatility of spreads has increased significantly, and some sectors of high yield – specifically Energy Services and small-mid cap E&Ps – are beginning to show the type of default risks last seen when oil tanked in early 2016. (Advantage bears).
• The critical 2-10y curve has not inverted (critical advantage bulls), but different tenors of the curve, specifically the 3m-10y and the 1-10y, are meaningfully inverted and have been for an extended period of time. Advantage bears.
• Allocations of new money to credit investments by pensions and endowments has not slowed down one bit from last year’s pace of about $200 billion (advantage bulls), but some of this money is starting to chase ever more leveraged assets at frothy high prices, thus leaving a thin margin of error. (Advantage bears with a longer time-horizon).
This is just a sample of the contrasting themes in the current credit markets, but it is plenty to give ammunition to those on either side of the market.
I remain in the camp that the credit bull market that began in January of 2009 will continue until the 2-10 yield curve inverts, with the corollary benefits of large stock buybacks and M&A activity. But just as I suggested nearly a year ago here – https://www.seeitmarket.com/change-in-risk-profile-corporate-credit-bonds-july-6/ – the risk profile for credit has risen another notch, and wading through the financial markets is getting a lot more tricky.
Twitter: @FZucchi
The author may have positions in mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
