Though credit spreads in the US are off their lows, they have remained relatively impervious to the heightening global risks surrounding trade and geopolitics. This partly reflects the strength in the US economy which has continued to support corporate earnings. With credit spreads in the US and Australia tightly linked, our spreads have also held at a low level.
As the Fed continues to push the federal funds rate higher, we are approaching the ‘neutral’ policy rate and therefore nearer the top of the cycle. It is rare policy remains at its plateau for a sustained period, and so it is not premature to start considering a turning point in the current expansion.
In assessing the risks, this piece will examine the historic dynamic between the US 10 year bond yield and credit spreads and questions why the relationship may be different in the current cycle. As Australian credit spread indexes only date back just over ten years, this analysis uses Moody’s Baa index as a proxy for general credit spreads*. While it references longer dated assets than the US 10 year, and comprises of US assets rather than Australian, chart 1 shows that it is a suitable substitute data series for the Australian 5y BBB index for the purposes of assessing cyclical trends.
In the post-stagflation era, credit spreads and the 10 year bond have shown a close negative relationship. Credit spreads typically lift from their bottom at around the same time the 10 year bond yield falls from its cyclical peak. As such, fixed rate corporate credit often tends to be in part naturally hedged with movements in the credit spread offset to varying degrees by movements in the ‘risk-free’ component.
A clear feature of chart 3 is the downward structural trend in the US 10 year yield as opposed to stationarity in the credit spread which has shown a firm support around 1.5% over the past three and half decades. On the other hand, the 10 year yield has moved lower on the back of the structurally lower federal funds rate and associated lower ‘neutral rate’. Therefore a clearer way to visualise the relationship between credit spreads and the 10 year bond is to look at the change in rates rather than the outright level. Chart 4 shows the weekly change in the US 10 year bond yield and the Baa credit spread from 1998.
There appears to be a fairly consistent negative relationship in times where the economy is expanding. But note the cluster of outliers to the right of the chart which emphasise the potential for outsized widening in credit spreads relative to the fall in bond rates during a credit crunch such as the GFC. Also, the extent that the purple dots (reflecting non-recessionary periods) are scattered shows that the bond rate and spreads can experience smaller financial cycles within the broader overarching economic cycle. The table overleaf shows the trough and peak of recent ‘risk-off moves’ in credit spreads and the coinciding move in the 10 year bond rate over the period.
In the ‘risk-off’ periods up to the GFC, the moves in credit spreads have generally approximated the moves in bond rates. However, the GFC saw an exceptionally large widening in credit spreads, well in excess of the decline in the bond rate over the period, which emphasises the potential for non-linear reactions.
The latest example through 2014-16 when a more moderate widening in spreads was met by a lesser decline in the bond rate bears of most interest for what may be ahead of us.
From July 2014 to February 2016, the Baa spread rose by around 1.4% whereas the bond rate fell by only 0.9%. Notable in this cycle was the starting rate of the bond rate which was much lower than that of previous ones – 2.6% compared to 4-7%. With the neutral federal funds rate having structurally trended closer to the lower bound, there is less room for bond rates to fall in an economic downturn. Consequently, the relationship between credit spreads and the US 10 year bond yield is likely to become increasingly non-linear even in less severe ‘risk-off’ environments.
To illustrate the above point, chart 6 looks at the Baa credit spread and the 10 year bond yield de-trended by taking the difference between the actual rate and its trailing three year moving average. The relationship has been very tight over the last thirteen years but there are two notable exceptions. The first was mentioned before, the 2014-16 period, and the second was the taper tantrum in 2013 where bond yields rose but credit spreads were relatively stable. It is likely that in the latter, higher bond yields were driven by flow effects (or expectation of flow effects) rather than strength in fundamentals which would typically see lower credit spreads. That has important implications for today’s environment given that the Fed is still quantitative tightening.
Our base case forecast for the US 10 year bond rate is a rise in the short-term to 3.5% in June 2019 followed by a decline back to 2.8% in December 2020 as the Fed stops hiking. Based on the historical negative relationship, this would see general credit spreads reach their lows by June 2019 and then start to widen from thereon.
It is important to note that our anticipated retracement of the US 10 year yield is quite shallow and is conditioned on a softlanding for the US economy. That then would be associated with only a moderate rise in credit spreads.
If a worse scenario were to take place and credit spreads were to widen more significantly, it is likely that the protection from a coinciding decline in the US 10 year bond yield would be more muted than in past crises. This is because we are closer to the lower bound in interest rates and there is less room for the 10 year to fall. On the other hand, credit spread widening is far off any potential limits to the upside.
Nevertheless, we consider the risks to the timing of our outlook are skewed to the upside. An extension of the hikes into the second half of 2019 would imply a lengthening of the current expansion and allow greater room for the 10 year to fall.
A second word of caution relates to the scope of this analysis. The history is deliberately chosen from the post-stagflation era. The unlikely (albeit still possible) return of stagflation would see higher and more uncertain inflation expectations, higher bond yields and higher credit spreads.