Good Thursday AM from your Hometown Lender,
Rates are settling down as trading is contained to the current channel (at least for the moment).
Unemployment claims came in lower than expected this morning (signaling labor market strength) and stronger than expected retail sales data (which is being attributed to higher costs from tariffs rather than increased volumes) could have hurt markets but did not which, adds more to the argument that we are staying within the current trading channel.
There was a brief period of volatility for bonds from the late morning through the early afternoon, when yet again rumors floated that led markets to believe that President Trump might try to fire Fed Chair Jerome Powell before Trump came out and said he wasn’t planning on firing him. Even then though, the statement almost sounded like a threat, with Trump saying, ““I don’t rule out anything, but I think it’s highly unlikely, unless he has to leave for fraud.” This was interpreted by many to think that Trump may try and use the overrun of spending on the Fed building as a means of fraud to get Powell out. The reality is that Powell isn’t going anywhere, and if he did it would cause at least a temporary shake up in markets where rates worsen.
A good primer from the WSJ on credit markets (vs equity markets).
Stock valuations can get elevated, frothy, ridiculous, bonkers—insert adjective here.
Credit is a different world, and that’s a distinction worth remembering right now. While the multiple of earnings or, in their absence, of revenue or eyeballs that investors will pay for a share of a company’s future knows virtually no limit, there’s a mathematical one for borrowing. We’ve pretty much reached it.
Take one measure of how risky investment-grade bonds in the most-crowded and lowest-rated BBB category are thought to be. This gauge, their option-adjusted spread, was near an all-time low this week at 1.01 percentage points. That doesn’t tell you actual borrowing costs but instead how much higher their yield is than the risk-free Treasury equivalent.
At that level, almost everything has to go right—risk with hardly any reward. Unlike Uncle Sam, companies can’t print dollars to repay you and their bonds can’t be bought and sold as easily.
Scary headlines can send credit investors scurrying, but exuberant ones will no longer push spreads lower. The BBB spread briefly hit 1.5 points around “Liberation Day” in April. When Covid-19 arrived, the spread went from 1.3 to 4.9 points before the Fed bought corporate bonds to calm markets. During the financial crisis it topped 8 points.
That meltdown seems like ancient history, but measures taken to prevent a repeat could create fresh problems today. Bank trading desks can’t step in to buy as many bonds as they used to, even as bond mutual funds are much bigger.
Those bond funds have proved to be durable. Newer structures haven’t yet. In addition to corporate bonds and bank loans, the $2 trillion private credit market has been opened to mom and pop investors. It’s even coming to staid target-date funds popular in 401(k) plans.
Many loans are owned by CLOs (collateralized loan obligations) that slice and dice risky credit into different categories, including super-safe tranches. Some of that repackaged debt is now owned by yield-hungy ETF investors too.
But for that magic to work, rules limit how much speculative debt can be part of those structures. If many companies face financial strains and get downgraded—for example, because of the trade war—CLOs may be forced to sell junkier debt.
Analysts at Rosenberg Research see more weakness in the junky part of the market than prices reflect. They calculate that speculative credit spreads imply a significantly lower default rate and higher economic growth than recent actual numbers.
Individual investors can usually be counted on to buoy swooning stock prices or to send them even higher. The credit market is different. It’s trickier to buy the dip and, after the recent rally, almost impossible to chase the rip.
Stay safe and make today great!