So Far So Good
USIG & KP Overview
Credit markets are expected to remain robust due to suppressed volatility.
My best pick remains on HYUELE.
While all asset classes have deviated significantly from last year's forecasts, credit markets have arguably presented the most surprising performance.
At the end of last year, credit markets had nearly reached the tightest levels seen in 2021, and the potential for further tightening seemed limited. Yet, this year, credit has been much stronger than anticipated, particularly in Asia ex-Japan, where the strength of Korean papers has led to tighter conditions than those of 2021. Corporate Investment Grade (Corp IG) is also very close to its historical low points.
Interestingly, last year's credit strength began with the Fed's pivot, but this year, despite a reversal of this trend, credit markets have strengthened further. Initially, the market had priced in approximately five rate cuts for 2024, but this has since been adjusted to just two. Nonetheless, as interest rates have risen, real money inflows have supported a bullish credit market.
The market attributes this strength to robust growth (the "good is good" scenario), the Fed's communication maintaining the possibility of three cuts within the year, and high demand from real money buyers.
While all these points may be valid, for trading purposes, the market's reaction to news often matters more than the news itself. I believe the most significant factor explaining this year's credit strength is the continued suppression of volatility, regardless of the underlying reason.
Starting with the rate hike cycle in 2022, credit spreads have shown a close relationship with the VIX. If one were to look at 2022 alone, or remember parts of 2023, it might seem that credit weakens as rates rise (i.e., when the Fed takes a hawkish stance). However, in the second and third quarters of 2023, credit actually strengthened as rates increased. Thus, it's difficult to argue that rising rates directly lead to weaker credit. Instead, credit weakens when rising rates cause market panic and volatility spikes
The years when rising rates contributed to increased market volatility include 2022, when the pace of hikes (25 - 50 - 75bp) shocked the market. This led to stagflation fears as the economy rapidly slowed, but interest rates could not be cut, keeping implied volatility at high levels throughout the year. Another period of high volatility followed the September 2023 FOMC meeting, which appeared hawkish, increasing concerns over further rate hikes until the Fed pivoted two months later.
Conversely, there have been instances where credit weakened despite falling interest rates, such as in March 2023 during the SVB and Credit Suisse banking crisis. This was due to fears of a credit crunch, leading to expectations of a Fed put, causing a rally in rates and a minor weakening in stocks, but a significant widening in credit. Periods where credit tightened even as rates rose without corresponding increases in volatility also occurred, such as from May to September 2023, before the FOMC meeting, when rising oil prices and increased Treasury issuance pushed rates up by about 100bp, yet credit spreads reached year-to-date lows.
In summary, it's challenging to directly correlate market interest rate rises with credit spread movements. It's more effective to associate credit spreads with the VIX or swaption interest rate volatility. And volatility tends to rise with unexpected external shocks.
Looking ahead, the risk of widening in the credit market appears to be more related to Fed shocks, supply shocks, or credit crunch shocks rather than merely rising rates. In the current context, this includes 1) a sudden hawkish turn by the Fed, with additional hikes not ruled out, 2) geopolitical risks such as tensions between Iran and Israel leading to oil price surges, and 3) asset quality deterioration, particularly in Commercial Real Estate (CRE).
The ffz4 - ffz5 spread will likely be an indicator for point 1). While the number of anticipated cuts has decreased from six to two this year, pricing for next year's cuts remains at 60~65bp. A reduction in the expected number of cuts next year would signal a genuine Fed shock.
Geopolitical conflicts, as mentioned in point 2), are unpredictable. However, the oil price peak seems near, as indicated by the nearing of last year's high point in the 1m-12m spread, suggesting that without additional supply-side shocks, oil prices are unlikely to surpass $90.
For point 3), offices, which constitute a third of CRE, are at a particularly high risk level, nearing those seen during the Lehman crisis. However, major banks have limited exposure to office CRE, which comprises only about 3% of the RMBS market, so it's premature to worry. Moreover, credit enhancements and capital buffers have significantly increased. For example, JPMorgan, which did not require bailout funds in 2008 and was relatively healthy, had a capital ratio of 8%. Most U.S. banks now have capital ratios in the 15% range.
Therefore, as long as interest rates rise, the entry of real money buying is expected to keep credit spreads tight. The most immediate risk seems to be this week's CPI release potentially causing volatility if it comes in higher than expected. In such a scenario, reducing credit positions would be advisable.
My best pick remains on HYUELE.
1. the current cycle just started, and ASP have soared faster than the previous cycles
2. if the history guides us, this cycle seems to be one of the big cycles memory semis experienced, (pc, mobile, servers).. and got a notched up at the start of the every big cycles
3. overall semis demands so resilient even without the actual cuts + ism manu pmi rebounding.. furthur rooms to be improved if the Fed acts
And also relative to MU or KP high betas (SAMTOT, DAESEC), HYUELE valuations seems very attractive.