6th February 2017

iTraxx/Cash… to diverge?

MARKET CLOSE:
FTSE 100
7,188, +48
DAX
11,651, +24
S&P 500
2,297, +17
iTraxx Main
71bp, -1bp
iTraxx X-Over Index
291bp, -5bp
10 Yr Bund
0.41%, -2bp
iBoxx Corp IG
B+134bp, unchanged 
iBoxx Corp HY Index
B+374.5bp, -1.5bp
10 Yr US T-Bond
2.47%, -1bp

Risk increasing, iTraxx north of 500bp?…

Separate ways? Cash and iTraxx

Don’t be daft, surely it couldn’t? It’s not been lost on us that recently, we have seen cash outperform the index even if the moves in either direction have been quite small. But can the cost of credit protection completely decouple from cash credit valuations?

In the broadest sense, the credit protection market is an insurance policy/hedging instrument designed originally to protect against credit defaults/weakening cash credit. However, quite early in its development it became a tool for taking a (short-term?) view on the direction of credit risk. The lack of liquidity, trading volumes and so forth in the cash market made it such that credit default swaps and the iTraxx indices have become the most effective of liquid proxies in which to take a view on the corporate bond market.

The liquidity of the iTraxx indices is probably a given, but we can’t say the same for single names. Single name liquidity has worsened over the past few years while, overall, one could argue that trading platforms have given us a false sense of liquidity/comfort because we see a “price” on the screen!

The cash market has been heavily manipulated of late, having earlier been bid-up by the huge cash levels looking for a better than government bond yielding fixed income market. An alternative safe-haven with some juice, so to say. The ECB’s foray through its QE purchasing programme has distorted the market much more, and the central bank’s holdings now account for almost €60bn of non-financial IG risk, or a little over 10% of the eligible market.

These bonds are going to be held to maturity. That distortive effect ought to ensure that the current macro and geopolitical ills keep the cash spread markets fairly well-anchored… or show only relatively moderate weakness in the event of a major macro/geopolitical disruption. Which brings us to the indices.

Can X-Over reach, say, 500bp or more (currently around 300bp) and cash not necessarily collapse? The IG cash index (Markit iBoxx) is currently at B+134bp and the HY index at B+375bp. Historically, we’re used to small periods where the moves in the two markets decouple for small periods, but where the cash market plays ‘catch up’ eventually, or the synthetic market recovers double-quick. They both collapsed (widened aggressively) when we have had the prospect of, or been join the throes of, a systemic financial crisis (2008-2009, for example).


In need of a systemic crisis

For X-Over to get near 500bp – or even shoot past it, we would need a systemic financial crisis – or a deep recession. For some, that might eventually no longer be a non-trivial probability with President Trump in charge. Not much further afield we also have the French elections becoming more and more unpredictable, while the removal of Merkel in the German elections come September would clearly add to the sense of crisis. The Italian elections are likely due sometime this year, too.

That’s an unlikely perfect storm of events which would need to be aligned.

For cash risk to come under fire, we would need fund outflows. The market has basked in the glory of the hugest of inflows ever seen since 2009 and the corporate market in Europe has almost tripled in size to €2trn since 2007. Outflows can only come, in our view, if we have high sustainable growth levels (credit to equity rotation) or that systemic financial crisis which sees the default rate exceed 10% say (currently 2.1%) and the bid for traditional safe-havens returns.

Admittedly, the mood in the market is very circumspect, and we do have many issues to contend with. But really, X-Over exceeding levels of even 500bp (amid a crisis) and cash holding firm is unlikely – and can only happen if investors don’t fret on the back of outflows derived form either higher growth/financial crisis.

French presidential candidate François Fillon

If X-Over heads north of 500bp, we would think that cash would have to widen too – but outperform – although there would be no decoupling in extremis. Remember, institutional investors will always be reluctant to reduce risk hard (only if forced to) because selling bonds means kissing them goodbye, such is the poor liquidity of the liquidity market.

Event risk is looming large but we wouldn’t be sticking our necks out just yet and think X-Over goes north of 500bp this year. It could, but it’s over to Trump, Fillon (or Macron or Le Pen), the Five-Star Movement or Merkel and the AfD. One of those could drop a geopolitical bomb which sees us over the line and upwards of 500bp on X-Over (as a measure of risk aversion – and panic), but there needs to be an even more serious shift in policy (US) and/or sentiment (Europe) for that to occur.


No wage pressure, the year’s performance is assured (!)…

That’s just how the markets played out in Friday’s session. Heading into the final day of the week, most were thinking in the context of a 2.80-3% like area for US Treasuries amid a welter of supply to come amid the prospect of higher inflation as the US heads for effective full-employment. We were completely wrong-footed.

Non-farm payroll additions of 227k smashed expectations (of around 180k) but there was nothing on the wage growth front – or very little, while the macro data exhibited some weaker than expected prints for January, too. There was also a little more around Trump/the EU/Iran and. Safe-havens (government bonds) were better bid on fear but also hopes that the Fed will not be raising rates in March, while equities rallied on hopes that the Fed will stay pat in March as well. It was good all around! The 10-year Treasury yield declined to 2.44% (-3bp).

Marcolin CEO Giovanni Zoppas

In credit, primary just delivered the week and month’s first HY deal with a €250m deal from Marcolin. IG non-financial credit drew a blank leaving the first three sessions of month to deliver €1.1bn of issuance from two borrowers.

It was blank in other areas too with spread in IG credit closing just a little tighter for choice, but with little appetite for secondary to really get going. The lower levels of issuance last week had no impact on spreads, with the cash indices in euro and sterling closing unchanged.

The HY market had a slightly better time of it with spreads 1.5bp tighter on Friday (Markit iBoxx), and a couple of basis points better in the week overall.

The synthetic indices closed with iTraxx Main at 71bp (-1bp) and X-Over at 291bp (-5bp). The Dow closed above 20,000 and the S&P was up 0.73% into last week’s close. Next week is about earnings again but let’s hope we get a few deals from primary credit.

Back tomorrow. Have a good day.

Suki Mann

A 25-year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on Credit Market Daily.