By any standard, credit spreads in the US bond and loan markets remain very tight. Now several years into a Fed interest rate tightening cycle, short-term interest rates are rising but spreads do not expand. A year ago the two year was yielding 1.35%, but today is 2.6%. The 10-year Treasury note, on the other hand, has barely moved in a year, 2.2% then vs 2.85% today. Last we looked, Treasury 2s vs 10s was 25bp compared to almost a point a year ago.
What a flattening yield curve and tight spreads say to us is that while the FOMC may raise short-term rate targets, in fact the demand for longer duration assets remains very strong indeed. Turkey or not, the 10-year rejects three percent yield.
The fact that the Treasury has greatly increased debt issuance also seems to have been shrugged off by the global debt markets. And the surging dollar is crushing global debt issuers like Turkey and Argentina, and the US benefits -- for now.
High yield corporate spreads remain below 400bp over the Treasury yield curve, according to ICE BAML. Spreads for “BBB” rated issuers are inside of 200bp over the curve and “AAA” rated corporates are inside of 50bp over so-called risk free rates.
As in 2007, all manner of idiocy is visible in the US credit markets today. Yet every news report about problems in the emerging economies seems to only increase demand for US sovereign risk. The combination of even moderately higher rates and credit crunch around the world has turned the US economy into a voracious, capital consuming black hole.
The reason that credit spreads are important is that when spreads rise, lending and capital formation tend to slow down – a lot. When credit spreads for high yield issuers rise above 500bp over the curve, risk lending by banks, funds and bond investors basically slows to a stop. The chart below shows the credit spread indices from ICE BAML c/o FRED with our annotations showing different policy actions by the FOMC over the past decade. Yardeni Research has a great annotated QE timeline.
If you compare the market actions of the FOMC and coincident movements in credit spreads, with public statements by Fed officials, a fascinating and somewhat confused picture emerges. But let's start with some context. Spreads were actually quite elevated in the early 2000s, both before and after the 911 attacks, but responded to Fed ease by gradually falling until HY spreads bottomed out at 250bp over the curve in June 2007. Indeed, HY spreads today are unchanged from a decade ago, just before the financial crisis.
With the failure of a REIT called New Century Financial and other private obligors in 2007, HY credit spreads exploded, hitting a near-term peak of 800bp over the curve in March 2008. By November of 2008, the failure of dozens of banks, non-banks and two of the four housing GSEs, caused HY spreads to soar more than 2,000bp over the Treasury curve and capital markets activity stopped. Private label mortgage paper was no-bid and even agency obligations were trading at a steep discount.
When the FOMC initiated the first quantitative easing (QE), the objective was to re-liquefy the banking system and force credit spreads down. We credit Fed Chairman Ben Bernanke and the FOMC for understanding the important of getting credit spreads to fall so that the financial markets could again start to function. Indeed, by March of 2010 when QE1 ends, credit costs fell dramatically with HY spreads inside of 600bp over Treasury yields.
Spreads rose again following the end of QE1, but over the summer the FOMC would announce the reinvestment of all securities purchased via QE1 and by year end announced further purchases via QE2 – even as credit spreads had begun to fall. By March of 2011, HY spreads had fallen to below 500bp over the curve. In September 2011, with credit spreads again starting to rise, the FOMC made a dreadful mistake. It decided to actively manipulate the Treasury yield curve via Operation Twist, selling short-dated paper and buying longer durations.
Ironically, the Fed commenced Operation Twist even though conditions in the bond market were already starting to improve. The FOMC noted in June 2012:
“This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
By December 2012 when Operation Twist officially ended, HY spreads had fallen to relatively normal levels ~ 550bp over comparable Treasury yields. Investment grade and high IG bond spreads were likewise compressed. The FOMC then trippled down via QE3 and continued to reinvest principal repayments in the System Open Market Account (SOMA) until the end of 2017.
Did the overt market manipulation of Operation Twist push down credit spreads as well as Treasury yields? Or did QE and the rollover of principal do the trick? We may never know which policy action was or was not effective. HY spreads bottomed out at 360bp over in June 2014. Credit spreads then spiked going into 2015 because of concerns about credit losses in the oil patch – losses which largely never materialized due to the surfeit of funds engineered by the Fed.
Spreads rose further early in Q1 2016 over concerns about an overheating Chinese economy. These fears then gave way to concerns about the November election and, surprisingly, the win by Donald Trump. But, again, credit spreads quickly retreated because of the huge amount of liquidity chasing too few assets. By the start of 2017, HY and IG credit spreads were back to decade lows, a reflection of the extraordinarily low credit losses experienced since 2012.
Did the overt purchases of securities and, via Twist, the deliberate manipulation of the yield curve, promote “a stronger economic recovery” that the FOMC promised? Maybe. But looking at credit spreads since 2015 when QE3 ended, a case can be made that the FOMC overshot the mark, first with QE3 and then by reinvesting principal through 2017.
The Fed's action will leave the financial markets badly distorted for years to come and with little to show for it in terms of growth. In particular, the long period of suppressed credit losses in the private sector (which are mirrored in the remarkably good bank portfolio data) suggest that credit losses are now going to follow interest rates higher – at least without further FOMC market intervention.
How long will it take to get to something like “normal” in the credit markets? Years. The chart above from Robert Eisenbeis, Chief Monetary Economist at Cumberland Advisors in Sarasota, shows the runoff of the FOMC’s system open market account or “SOMA.”
“SOMA has actually bought some securities and sometimes on a weekly basis the portfolio has increased. MBS runoff has been slower than projected but they have not sold assets,” as Eisenbeis told us in a discussion last year. “If runoff is greater than the target, their policy calls for reinvestment, which they did, especially early on when the caps were small.”
As the FOMC decreases their share of Treasury and agency securities relative to the portion held by private investors, credit spreads and loss rates more broadly should also revert to the mean. Newbie fintech lenders will cry terrible tears as the cost of credit appears in the portfolio of home improvement/flipper loans they’ve assembled using "artificial intelligence." And commercial as well as residential loss rates will also revert to the mean.
Projected Evolution of the SOMA Portfolio and the 10-year Treasury Term Premium Effect
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