Citi: “2018 Is Not Going To Plan”

Discussing recent trends in the bond market, Citi’s credit strategists point out that there have been a lot of surprised traders this year, because i) the first half was supposed to be fine “like last year”, and ii) IG was supposed to keep outperforming HY.

And yet, contrary to expectations, both investment grade and junk bond spreads blew out in the past few months, catalyzed by the spike in real yields, the February VIX/vol ETN fiasco, the surge in $ Libor and the recent escalation in the US Chinese trade war…

… which in turn has sent the HY/IG ratio tumbling, as junk has sharply outperformed IG.

This led Citi’s Hans Lorenzen to conclude the “2018 is not going to plan“, prompting him to ask what’s going on: “a succession of unhappy coincidences or something deeper?”

This paradox is accentuated when considering that the fundamentals behind credit corporates still remain sound, including corporate deleveraging among the Top 25 largest companies, a thrifty approach to spending cash and not lavishing shareholders…

… which also mean there has been little rating deterioration and more positive than negative reviews.

Other favorable catalysts include contained corporate supply (as in no net issuance to buy for private investors when taking the ECB’s CSPP in consideration), a relentless bid from the ECB even as deposits have continued to accumulate across Eurozone banks, with the ECB’s negative deposit rates having little impact on savings.

And yet, Citi notes that while fundamentals do support tight credit spreads…

… they do not support spreads “this tight.”

But what got us here in the first place? We will spare readers Lorenzen’s favorite chart, which shows the unprecedented increase in central bank balance sheets in the past decade…

… or rather we won’t, because as Citi’s bank strategist writes, what got us here is “central bank distortions” which have manifested themselves in three main ways:

  1. Money crowded out of govt bond space flows into IG (and HY) credit, boosting private demand. Quantity reduces already in Jan. 2018.
  2. CSPP reduces quantity of bonds available to private investors until Sep./Dec. 2018
  3. Negative deposit rate raises opportunity cost of not taking risk boosting private demand. No change in the Eurozone until 2019, but watch Fed’s impact on $ curve

However, as central bank purchases diminish, the equilibrium shown above will shift again, resulting in far higher spreads.

Ok fine, but everyone knows that QE is ending: the phase out will be predictable and priced in, plus since the ECB only buys IG bonds, it’s most an IG factor. Well, maybe not: consider the following correlations showing the dramatic impact QE has had on HY spreads.

Of course, it was all fun and games for years, when thanks to QE from either the Fed, BOJ or QE, the net supply of securities was negative, or in other words, “when there’s more money than assets, everything rises.”

But that too is changing, and over the next few months, the net supply of securities in advanced economies is set to soar, begging the question: who will replace the ECB’s buying at these record high prices.

Said otherwise, there is a $1 trillion increase in the private funding requirement in 2018. At what yields – or equity prices – will this happen?

So as we trek on while central banks continue to pump less and less liquidity, the sweet spot for credit is becoming an “ever thinner wedge” as shown in the right-hand chart below prompting some potentially adverse outcomes including a restrictive central bank policy, policy efficacy in doubt, and in the context of policy mistake fears and blowing out spreads, a recession. Meanwhile, Eurozone monetary policy has rarely been looser, meaning that as the ECB tightens, the only outcome is an adverse one.

Meanwhile, in the next unintended consequence, as economic slack diminishes, debt financing is likely to increase…. just as yields start blowing out and the biggest net buyer – the world’s biggest hedge fund, the ECB – heads for the exit.

Which brings us back to square one: will the central bank exit be enough to catalyze the next crash? Lorenzen’s answer is that the CB exit may be too obvious a trigger to launch the next drop in risk assets, it reintroduces all those vulnerabilities that will facilitate it, and which the market largely has ignored for years.

What happens next? The simple answer, as such a coordinated global withdrawal of liquidity has never before been attempted, is that nobody knows, but according to Citi, as the central bank backstop moves “out of the money”, volatility should increase and risk/reward finally become more asymmetric…

… resulting in the following preferred trade strategies as we finally enter the uncharted territories of the “great unknown”, which maximize carry relative to beta (translation: have one foot out of the market).

Lorenzen’s conclusion: the artificial central bank “sugar high” is almost over, leading to growing risk of a major market tantrum, keeping Citi as underinvested in the market as possible.

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