Credit Market Daily #36

17-October-2022

Good Morning!

This is a catch-up piece – apologies for a lack of a note on Friday. Circumstances did not allow for its production.

Thanks to everyone who attended the European High Yield Q4 Investor Survey Webinar on Thursday. For those who did not attend there will be a video available on the site shortly.

In terms of catalysts this week, today we have Eurozone CPI, Jeremy Hunt making a speech on his plans to bring stability and the Empire Manufacturing index in the US.

Then later this week, Germany’s consumer confidence (will it improve?), US capacity Utilisation, UK CPI on Wednesday, UK consumer confidence, PMIs for Europe and the US.

So What Has Changed?

1. UK Gilts, Will The Bond Vigilantes Call Time on Truss, UK Credibility Gap
2. CPI data came in hot for the US
3. Unhealthy Equity Price Action

Let’s look at each one in turn

UK Gilts, Will The Bond Vigilantes Call Time on Truss, UK Credibility Gap

Thursday and Friday saw the Bank of England intervene in the Gilt Markets for the last time as part of their backstop program. Bloomberg provides the breakdown of their £19.25/63bn of emergency purchases below.

Gilts experienced relatively large swings in yield over the last two days, rallying on Thursday with expectations that Truss would fire her Chancellor, and reverse some of the unfunded tax cuts.

Come Friday, that rally had all but evaporated and the consensus appears that the Gilt yields are going to continue to rise until the PM gets the message and resigns.

Gilts look to be opening tighter by some -20bps across the curve undoing Friday’s move given the announced Tax u-turn and expectations of further sensible policy.

As readers of this note will know expectations leave the door open for disappointment, hopefully, the new chancellor gets it.

For the PM, Truss’ goose appears well and truly cooked with calls for her to go likely to increase from within her own party this week.

How quickly she goes is anyone’s guess, but I think you can measure in weeks not months.

In the meantime, I expect volatility in the Gilt market to increase and UK corporate bonds to remain under pressure.

Markets like certainty – and Hunt giving a speech outlining his plans today which could be a positive catalyst.

The good news is that if Truss were to go, there is a clear catalyst for a rally.

The bad news is a near-term sell-off is a real probability if markets want to force the issue.

Any level which we rally back to is likely to reflect a relative discount due to the UK’s now-dented credibility.

Looking at CDS markets – UK CDS has narrowed from 49bps to 43bps and the difference between it and Germany’s CDS has declined from a peak of 25bps to 15bps, suggesting UK risk is recovering somewhat.

Rates seem to be telling a different story.

With parallels in the press made with Italy’s volatile governance, the difference in yield between the UK 10-Year Gilt Yield and the 10-Year BTP yield has actually become less negative.

The difference between the 10-yr Gilt and 10 Yr-Bund Yield is 199bps, a level not seen since 1991.

So there is some way to go, before credibility and the base price for UK risk return to pre-Trussenomic levels.

Add to that the Bank of England removing the training wheels on the Gilt markets bike and we could be in for quite the week.

UK CDS tightening relative to German CDS

10 Year Gilt Yields are moving closer to those of Italy

.. and are at their highest vs. the 10-yr bund since 1991

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CPI

US CPI was higher than expected and continues to support hawkish Fed action.

In YoY terms, the index came in at 8.2% which is the 3rd sequentially lower month for the index on a YoY basis – this decline is expected to continue.

The focus is really on the MoM numbers and these have been increasing sequentially since bottoming in July.

The top-line message is that there was no let-up and the higher expected Month on Month numbers mean that the market is now pricing in a small, close to zero chance probability of a 100bp hike at the November Fed meeting.

50bps is off the table now and a 75bp hike is baked in.

So no Pivot. In fact, in Thursday’s webinar, a “Pause” rather than a “Pivot” is what Mahesh Bhimalingam believes is the best we can hope for.

Still, he expects, any pause to be a catalyst for the USD to depreciate as other central banks keep tightening, which should then lift risk assets.

In terms of CPI components – the MoM rise comes from medical care and rents. Rent is a lagging component so will continue to exert upward pressure on CPI in the coming months.

The ever-excellent Patrick Zweifel from Pictet Asset Management breaks it down below – the nub of it being that he expects inflation to continue to decline driven by other items in the index.

He expects core inflation to end in 2023 at around 3.5%, above the Fed’s 2% target. This means higher rates for longer.

Measure	MoM Expected	MoM Actual	YoY Expected	YoY Actual
CPI	0.2%	0.4%	8.1%	8.2%
CPI excl. Food and Energy	0.4%	0.6%	6.5%	6.3%

Ian Shepherdson, Chief economist at Pantheon Macroeconomics shows the Zillow rent index peaking YoY against the “sticky” Owners’ Equivalent Rent component of CPI – so like Patrick Zweifel expects the rent component of US CPI to roll over:

Lastly, a chart from Bank of America puts the MoM moves in CPI in context – a pace of 0.2 MoM CPI would still leave CPI at 3.1% by the middle of next year c.50% above the Feds 2% target.

All in all a “Pause” looks a lot more likely than a “Pivot”. Something to bear in mind for future CPI prints and resultant market rallies.

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Equities – Big Swings

Thursday’s intraday move in US equities was impressive.

The CPI saw a market initially sell-off, which given the “Pivot” hopium, you would expect.

The S&P 500 was down -2.25%.

And then? Well, the index ended the day UP 2.6%, registering one of the largest intraday swings in a long time.

SPX’s intraday swing

The Vix touched 33, with Pandemic highs of 88.

The discrepancy between the two has lasted a long time with the 2 indices beginning to diverge in October ’21.

Now, you can easily argue that the last few weeks’ moves in government bond yields should mean MOVE raced higher.

The issue is that the moves in FI impact liquidity, which impacts leverage, which impacts equity prices. And we have yet to really see this play out.

The Bank of England was very concerned about containing any contagion from the leverage destruction in the LDI complex leaking into the broader markets for example.

In my mind, it is only a matter of time before we see more impact from reduced liquidity in equities.

The Vix is pricing in a lot less risk, the size of the catch-up with the MOVE index would require some serious downside in equities. (see What caught our eye for some charts on positioning and sentiment).

Of course, the Vix could be right, but given equity valuations I find this hard to believe.

Fixed Income Vol close to Pandemic Wides, Equity Vol Is Not Even Close

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Credit

High Yield

Fedrigoni priced its High Yield deal – bringing supply to a very quiet primary market. The speciality paper and adhesives company, rated B+ at S&P and BB- expected at Fitch paid up to come to market.

The company issued a €300mm 5 Non-Call 2 bond at a price of 97.25 to yield 11.75%, with price talk of 11.75%-12.00%.

Additionally, they issued a €572.66m 5 Non-Call 1 note at a price of 91 with a spread of Euribor+600bps, private exchange of €152.34m brought the tranche size to €725mm.

For context, the European High Yield single B index yields 10.25% and the BB index 7.62%. Overall the deal was upsized from €875m to €1.025bn

We covered expected supply in the High Yield Investor webinar, with c.€11 bn of issuance expected for the quarter this deal represents 9% of that.

Survey correspondents have consistently underestimated issuance in good times and overestimated it in bad times.

Cash levels are at a record high and the relative underweight in high yield was flagged as a very powerful technical factor.

Mahesh said he expects it will cause a “rip” higher in prices once we have navigated our way through the trough in prices which he expects in the next 3 to 6 months.

Month to date, Euro, Sterling and Dollar High Yield Indices have returned -44bps,-134bps and +29 bps respectively.

Spreads were tighter on Friday, recovering from Thursday’s move wider with rates driving total returns.

I still expect us to move wider.

Leaders and Laggers

Investment Grade

Investment grade had a relatively flat day on Friday but underperformed High yield driven by rates.

One of the main highlights of the Q4 HY investor survey webinar was that IG is favoured over high yield for a number of reasons.

When the video is on the site I recommend that you watch it. It is the first time investors have favoured the asset class over high yield in the Survey’s (short) history

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Rates

Rates gave back their gains on Friday led by Gilts which moved wider for the reasons outlined above.

The 10-year Treasury, Gilt and Bund Yield 395bps, 412bps and 225bps respectively.

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Equities

Equity futures are opening down in Europe and Higher in the US the opposite of Friday’s closing price action.

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Today’s Events

Eco Data

UK house price moves – +0.9% MoM vs. 0.7% previously and the Empire Manufacturing Index in the US.

Today’s Reporting

Matalan Q2 – check our feed for a summary later

What Has Caught Our Eye

Stanley Druckenmiller – on Inflation, Rates and a Hard Landing

“Once inflation goes above 5%, it has never come back down without the Fed Funds Rate exceeding the CPI”
Stanley Druckenmiller

US CPI (inflation) for Sept was 8.2%
pic.twitter.com/PncqOOA8Ev

— Wifey (@WifeyAlpha) October 13, 2022

Some Charts on Equity Valuations, Sentiment and Positioning

European Equities look cheap, US Equities have a long way to go, and US earnings expectations continue to head lower.

Positioning and sentiment remain bearish and supportive of risk on should we rally.

Performance

High Yield

Investment Grade

Rates

Equities