Merrill Lynch on Credit Spreads and Other Stuff

April 29th, 2015 7:48 pm | by John Jansen |

Via Merrill Lynch Research:

  • Tail wagging the dog. Our core view is that over the next year or two we will see higher interest rates and wider credit spreads, as the Fed unwinds its massive monetary policy easing cycle. That positive correlation has been on display the past two days as interest rates rose significantly and credit spreads widened. Today we even saw negative correlation between rates and stocks. Usually we think about interest rates set by our big brother – the Treasury market – as the driving force for spreads. However, apparently liquidity in the Treasury market has declined so much that sometimes causality goes the other way. Hence some talk in the markets about heavy corporate supply – both volumes and higher than normal duration (see: (Companies) Sell in May and section below) – weighing on Treasuries the past few days. Of additional focus – and equally impossible to show – the busy corporate M&A calendar raises the possibility that rate locking plays a role as well for the rise in rates.
  • Equally unusual was today’s negative correlation between the US economy and interest rates as 1Q GDP growth disappointed (see our economists’ assessment below). However, today’s huge 12bps jump in 10-year Bund yields presumably was the main driver, as a partial unwind of the effect that declining global yields helped take US rates lower over the past several months. Below our European colleagues attribute the sell-off in Bunds to better news out of Greece, and then today better than expected M3 data and a weak German 5-year government bond auction. Additionally we would pose that perhaps the fact that a number of high profile investors recently have expressed very bearish views on Bunds was a factor as well.
  • From our side nothing has changed since Friday – we still think that an extremely busy new issue calendar in an environment of increasing rate hiking risks will drive credit spreads wider in May. Moreover it appears that dealer inventories of IG corporate bonds are already back toward the $12bn peak level from the last time we had significant supply volumes coming through in March. To be clear the most recent official data from the Federal Reserve shows dealer inventories in IG of $8.5bn as of April 15th. However, augmenting with Bloomberg data through today shows an estimated increase to $11.5-12bn – mostly longer maturities (7+ years) by the way. That translates into limited ability of dealers retaining/helping to make room for new issues. An increase in demand would help, but the decline in bond prices makes it unlikely that retail inflows will be meaningful going forward. – Hans Mikkelsen (Page 5)
  • Locking in low yields. Longer than average duration has been the notable feature of high grade supply recently. So far in April duration has averaged 8.7 (weighted by the amounts issued), significantly above the 7.5 average for the period Jan-14 through Mar-15. Durations have been particularly high this week (through Tuesday) on the back of the ORCL deal. In fact, the two largest deals over the last two weeks (T and ORCL) were more heavily weighted in the intermediate (7 to 15yr) and long (15+yr) parts of the curve relative to history. This trend to issue longer bonds likely reflects that companies are finally rushing to lock in historically low yields levels before interest rates go up as we approach the Fed’s tightening cycle. We expect this trend to continue into May. This longer duration should amplify the market impact of the expected acceleration in new issue volumes in May (see (Companies) Sell in May), that we expect to come in the $100 to $140bn range. Moreover, May supply is typically concentrated among non-financials, which have accounted for almost 70% of the total supply for the month, on average, since 2010. Non-financial supply is generally longer relative to financial supply. – Yuriy Shchuchinov (Page 7)
  • April FOMC: nothing to see here, move along. As we anticipated, Fed officials acknowledged the 1Q data disappointments, but saw that as partially “reflecting transitory factors.” More importantly, Fed officials did not change their assessment that the economy will gradually improve to achieve the dual mandate objectives, despite the recent weakness in activity. In addition, as expected, the FOMC did not formally rule out a June rate hike or suggest that liftoff would be delayed. Rather, as communicated previously, policy decisions will be made on a meeting-by-meeting basis. While we think the chance of a June hike remains very low, we remain comfortable with our long-held call for a September liftoff. Given recent data softness, risks are skewed to a later start to hiking. – Michael S. Hanson, Priya Misra, Ian Gordon (Page 9)
  • Do you trust the ECB?. Testing the ECB’s mettle. During last week’s ECB press conference, President Draghi was tested on two key questions: 1.) Can the ECB cut rates again? 2.) Will the ECB taper QE purchases before September 2016? Draghi answered both questions with a resounding “no”. Interestingly, the market does not seem to believe the answer to the first of these questions, but trusts the ECB with the second. – Ralf Preusser, Sphia Salim (Page 10)
  • GDP: too weak to ignore. Who said history doesn’t repeat? The economy only expanded by 0.2% in 1Q, coming in below consensus expectations of 1.0% and our forecast of 1.5%. This is the exact same story as last year – the consensus was for low-1% and the first estimate of GDP was 0.2%. But last year, the data were subsequently revised even lower to -2.1%. And, it was easier to explain away the weakness from abnormally harsh winter weather and peculiar swings in a few of the components of growth. While there are “special factors” this year as well, including a port shutdown on the West Coast and poor weather in February, we are less comfortable dismissing these data. – Michelle Meyer, Ethan S. Harris, Alexander Lin (Page 11
  • Europe: Credit dynamics: we remain upbeat. Net flows of loans to the non-financial sector (households and non-financial corporations) did not do as well in March as in February, at EUR10bn against EUR 18bn (corrected for securitization), but we remain reasonably upbeat on the credit cycle. First, these series are extremely volatile, and we note that the flows in March outperformed January (EUR 7bn) and that they have systematically remained in positive territory since August 2014. This is the longest string of net credit origination since 2011. In 2013/2014 the Euro area went through 15 months of uninterrupted negative flows, averaging EUR 8bn per month. Since August 2014, flows have averaged +EUR 7bn. In annualized terms, this is turnaround of 1.8% of GDP. Second, a lot of the disappointing figure for loans to the non-financial corporations at the Euro area level can be attributed to de-leveraging in Germany while flows are getting healthier in Italy and Spain, where they really matter. Third, since December 2014, the ECB has re-classified the loans to the holding companies of non-financial corporations into “loans to non-MFIs except insurance corporations and pension funds”. The central bank does not provide a breakdown for this category, but flows there have reached EUR 14bn in March, the highest level in a year, against EUR -3bn in February. When consolidating loans to the non-financial sector with this hybrid non-MFI item, the sense of acceleration is obvious (EUR 10bn in January, EUR 15bn in February and EUR 24bn in March). – Gilles Moec (Page 12)
  • Italian politics back in the spotlight. Confidence vote on electoral reform: what is market impact? Controlling market contagion from Greece is conditional on the absence of political noise from the rest of the periphery. The latest news from Italy – with a surprise confidence vote on important electoral reform – is therefore unwelcome for the market, in our view. However, we think that the current government should survive this ordeal, which means that wobbles on Italian, and peripheral bonds in general, should remain in check. Ruben Segura-Cayuela, Gilles Moec (Page 14)
  • Housing momentum. Pending home sales added 1.1% mom in March, coming in slightly above expectations of a 1.0% mom increase. The index reached the highest level since June 2013. February growth was revised up to 3.6% mom from 3.1% mom initially. The South and the West saw pick-ups of 4.0% mom and 1.7% mom, respectively, while the Midwest and the Northeast saw slow-downs of -2.5% mom and -1.5% mom each. In our view, the housing data have shown greater momentum after the difficult start to the year. – Alexander Lin (Page 12)
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