Think Big: Credit markets are still the one to watch as global economic shocks continue
With the pace of news flow and levels of volatility across asset classes, it’s hard for investors to keep up amid the COVID-19 crisis.
Stocks are crashing, and yesterday the Australian dollar briefly fell to its lowest level since 2002.
But just as important are the unusual signals being flashed by credit markets as the global economy faces an unprecedented test.
We took a look at bonds in last week’s Think Big. But a week is a long time in the current climate, and at the time of print credit markets are still under pressure and worthy of further examination.
Asian trade yesterday followed on from a monetary policy bazooka fired by the European Central Bank, which announced a €750bn ($1.44tn) asset purchase program to help maintain liquidity in the Eurozone.
And domestically, the RBA announced a coordinated response where it cut benchmark cash rates again to 0.25 per cent and created a $90 billion funding facility to help foster lending to small businesses.
It also said it would start purchasing government bonds with the aim of maintaining the three-year government bond yield at 0.25 per cent to help foster stability and liquidity in the Australian financial system.
While central banks deploy tools to combat the crisis, it’s clear the economic threat posed by the pandemic has still prompted some erratic moves in the bond market. To try and make sense of it all, Stockhead caught up with Tim Kelly, who manages the fixed income portfolio at Australian Ethical Investment (ASX:AEF).
Kelly highlighted the importance of stability in government bond yields, which act as the “bedrock” on which other assets are priced.
Yesterday, benchmark Australian 10-year bond yields jumped around by over 30 basis points — a rare move which creates “volatility for the rest of the markets”, Kelly said.
At the same time, debt markets across most developed economies have seen a rapid increased in the yield spread between corporate debt and government bonds.
Yesterday, spreads on investment-grade corporate debt in Asia jumped by another 20 basis points (0.2 per cent) while in the US, the spread rose to over 300 basis points — the highest level since July 2009.
Europe’s primary bond market was closed on Wednesday, although yields fell sharply when it reopened in the wake of the ECB’s stimulus.
Kelly said that widening spreads raised concerns about a “contagion effect” across markets. But closer to home, it’s all about liquidity.
“In terms of the domestic market, I don’t think spreads are reflecting an underlying concern about credit risk,” he said.
“However, spreads are now reflecting a complete lack of liquidity in this market. And so spreads blowing out is a sign that if someone wants to transact from their fund, they can fund that through selling government bonds. They should still be able to fund it throughs semi-government bonds (debt issued by state and territories).”
“But as you move down the credit spectrum (towards corporate debt), it’s becoming more and more illiquid. So the size of the bid you can expect to receive for a credit instrument is getting smaller.”
And even in the market for Australian government bonds, there was a sharp move at the longer end of the curve in response to yesterday’s RBA stimulus.
The central bank said it would carry out bond purchases in order to keep the three-year yield at 0.25 per cent. But in response, futures markets for longer-term 10-year bond yields — generally regarded as the benchmark for bond pricing — started to climb rapidly.
Speaking to Stockhead before the RBA announcement yesterday, Kelly pointed to the unusual events of the previous seven days.
“I think going into last week, there was still hope of a fiscal and central bank response to what was an evolving crisis,” he said.
Kelly noted that on Monday of last week, Australian 10-year bond yields fell to an all-time low of around 55 basis points (0.55 per cent), in anticipation of the shift.
A coordinated response from the government, the RBA and financial regulators has now been carried out. But at the time of print, Aussie 10-year bonds were back at around 1.5 per cent — a very sharp move by bond market standards.
“For us to now be 100 basis points above last week’s level, to me indicates either fear has entered the markets, or dysfunction. Or a combination of the two,” Kelly said.
And as the “bedrock” of other asset classes, the ability of policy makers to restore a level consistency to underlying credit markets will be a key theme to watch in the weeks ahead.