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The market tries repeatedly to assess the top of the Fed & ECB hiking cycle. If it is an overshoot, a recession is very likely and Bloomberg economic consensus is currently a 72.5% chance of recession in the Eurozone and 50% in the United States.
A complex game of musical chairs
Credit is often referred to as a game of musical chairs. As long as the central bank’s music entrances the dancers all is well and credit rallies as covenants asked by bondholders are ever less demanding. Once the music stops, one of the dancers is left without a chair to sit on and indeed no luck. This is often the case ahead of a recession or as a central bank rapidly tightens monetary policy.The risks faced by credit investors are from the rate hiking cycle, rising credit risk with longer dated bonds and liquidity risk, as buyers are few in a crisis. Add to this sovereign, political and legal risks and what seems like a simple exposure in good times becomes a far more complex one under stress.
A case in point are UK pension funds running Liability Driven Strategies that borrowed heavily to buy long-dated UK fixed income and equity while posting ABS and especially Gilts as collateral. As Gilts yields rose 50 basis points within a day (due to an unfunded budget announcement), some of these pension funds were left without enough liquidity to cover margin calls as they were overly invested in illiquid private assets. It is a fine long-term strategy shared with Canadian pension funds, but it left them with a risk management quandary. That emergency forced the Bank of England to react and buy long-dated Gilts.
What happened?
As the ECB and Fed started their tightening cycle including Quantitative Tightening in the US, back-end swap yields moved higher. More recently, the market has focused on the risk of overtightening leading to a Fed pivot to eventually loosen monetary policy rather than stay on hold next year. In the swap space, credit risk has seen a significant increase driven by fears of a recession but especially a dearth of safe-haven assets such as Bunds (High Quality Liquid Assets needed in Banks’ Liquidity Coverage Ratio).
As considerations of a potential US recession fluctuated, the higher tranches of credit risk (e.g. CCC) have come under pressure. The market continues to hesitate on the intensity of the coming slowdown/recession which means that the better tranches of credit are still far from distress levels. The same can be said in Europe.
In the next few weeks and months, we should be able to fully price-in the Fed’s & ECB’s dovish pivot with its consequent rally in bond prices. With the shape of the potential recession ever clearer so will the odds of defaults leading to a probable rally in Credit. We are not there yet and we continue to prefer the safety and ability of managed Covered Bonds.
