A look into the recent volatility

Our H2 outlook started off by commending the exceptional resilience of the credit markets over the first half of the year even as investors had to contend with the emergence and fast escalation of the Ukrainian-Russian conflict, Emerging Market volatility, elections for the European Parliament and recurring signals that China is slowing. A few months later, markets have become increasingly sensitive and volatility has increased proportionally. Whereas this could only be a normalization of the volatility that is due to characterise the risky assets such as equities and high yield, we cannot help notice what a difference a few days makes. What really changed lately to cause the moves we have seen over the past week?

Coincidentally or not, the selloff started last week with the below expectations. US retail sales data that came out shortly after the Fed minutes spoke about possible contagion effects from a weakening growth outlook abroad and the downside risks of a stronger USD. Among the most notable moves, we note the significant repricing of the US treasury yield curve which points to a reassessment of the future Fed monetary policy. More specifically, the short end of the curve, which is inherently sensitive to changes in the Central Bank rate, moved significantly lower, with the 2 year rate falling to 0.35% from 0.5% when the month began and reaching the lowest level in four months. But the change in expectations is perhaps more easy to gauge by looking at the futures-implied Fed rate and it is here where we found that the hike in rates is now expected to come later and progress at a more gradual pace (see Charts on the left) than had been previously anticipated.

Since such a shift was said to have been triggered by a change in growth expectations, it makes sense to look next at the trend in economic surprises. Making use of the Citi US Economic Surprise Index (CESI USD), we find that this indicator has been trending lower since September but most of the deterioration occurred over September and, even so, the level is still commensurate with positive surprises (see Chart).

However, when we put together the recent drop in Citi Eurozone Economic Surprise Index (CESI EUR), the Fed acknowledgment that slowdown elsewhere can affect the US and the disappointment in US consumption indicators, we feel we gain some insight into investors’ reaction. CESI EUR has been rapidly dipping into negative territory (see Chart), whereas in the US, indicators relating to the domestic demand such as income or retail sales have been mixed and recently surprised negatively; the latter probably made investors worry somehow that the US domestic market cannot offset weaker demand elsewhere and the dovish warnings of the Fed minutes became in this context overweighed.

Nevertheless, in my opinion it could be that markets did not downgrade their growth expectations so much as they lowered their inflation forecasts in face of a stronger USD, of recurrent deflationary risks in Europe and slipping commodity prices. These three factors lower the costs in the US as they keep the cost of imported goods at bay and, as such, should allow the Fed to maintain an accommodative monetary policy for longer. In the same vein, the substantial drop in the 10 year US Treasury rate (which in any case defeated the consensus estimate this year), could be justified by the sizable yield pickup that this offers relative to the Euro area yields. That is, a postponement in Eurozone’s recovery would imply lower rates for longer here and hence, could support the demand for US Treasuries in view of the higher return of the latter. This scenario would also explain the underperformance of the European markets relative to their US markets in the aftermath of last week’s reversal.

Where does this leave us? It is certainly too soon to tell if the scenario I propose above is indeed accurate but if this is the case, the US credit market could become increasingly appealing as the economic backdrop remains supportive enough, yields are higher and interest rate risks appear to have diminished; the labour market and the housing sector data suggests that the momentum remains strong whereas the confidence indicators are reassuring (see the Bloomberg Surprise Index by Sector below). Thus, the next challenge that the US High Yield appears to be facing now is that investors will prefer complacency and settle for what could be a technically better supported market – EUR High Yield.

We, along with other analysts, were forecasting that given that the ECB is still in easing mode, creating extra liquidity and encouraging indirectly the run for yield, European credit will outperform even as the economic context is more concerning than in the US. In my opinion, it is less clear at this stage that investors remain ready to discount the fundamentals and given that the ECB’s ammunition is more limited now and investors more prone to fatigue, we could see a “return to fundamentals” if it fails to lift inflation expectations and hopes for stronger growth. Indeed, notwithstanding the measures announced over the last few months, inflation expectations remain at low levels and the outcome of the December TLTRO has become more important for the markets’ sentiment. What is more, much has been said lately about the need of complementing the ECB’s efforts with non-monetary measures (such as structural reforms and spending programmes) but limited if any progress has been made. This again, can hurt sentiment and reduce the search for yield.

In the event that the scenario mentioned above fails to materialize and growth in the US weakens by a larger margin, one could still argue that the risky assets here could prove more resilient unless the technicals overpass fundamentals; whether this can happen hinges on the same factors I mentioned above and to a large extent comes down to how successful policymakers are in managing sentiment.