The recent spike in Treasury yields has drawn comparisons to the 2013 Taper Tantrum, when uncertainty over how the Federal Reserve would adjust monetary policy pushed up yields on ten-year Treasuries by almost 150 basis points over just four months. Superficially, the two episodes share similarities. In both, an unfolding recovery prompted renewed focus on prospects for policy tightening. But we see meaningful differences between them, with important implications for credit markets.
The 2013 Taper Tantrum was primarily a monetary policy shock; investor concerns that the Federal Reserve was making a policy error drove up rates and initially widened credit spreads. This year, by contrast, investors expect sustained fiscal support and the ongoing vaccine rollout to boost the economy. Those expectations have driven up Treasury yields but narrowed credit spreads; both investment grade and high yield debt have outperformed Treasuries (Figure 1).
Figure 1: Cumulative Excess Returns Per Basis Point Rise in 10yr Treasury Yield 1
A different period of rising rates is more comparable to this year: late 2016, when Donald Trump’s election victory sparked hopes that tax cuts and deregulation would boost the economy. In that period, too, investment grade and high yield debt outperformed, as Figure 1 also shows.
Current Outlook for Credit
We think the current environment remains supportive of US credit spreads, particularly the lower-quality portions of the investment grade and high yield markets. We expect stronger consumer spending on the back of the ongoing vaccine rollout and the tailwind from fiscal policy to translate into improved earnings for issuers. Second, we expect the Federal Reserve will continue clarifying its forward guidance on monetary policy, leading investors to reassess their current expectations for asset purchase tapering and liftoff, which in our view are overly aggressive given that it will take some time for the economy to reach maximum employment and for sustained inflation pressures to emerge. Finally, there is a limit to policy-makers tolerance for higher risk-free rates. If a further rise in rates leads to a meaningful tightening of financial conditions, we would expect the Federal Reserve to respond by lengthening the maturity of its asset purchases or even temporarily increasing the pace of purchases.
In terms of corporate credit fundamentals, beyond the positive impact of stronger growth on profits, we have also taken note of management teams finding significant cost savings as they adapted to the pandemic. In addition, management teams took advantage of highly accommodative monetary policy last year to build up precautionary liquidity (Figure 2). This should provide flexibility to adapt to any move higher in interest rates. And looking specifically at the high yield market, the quality mix of the market is extremely high at present. Recent downgrades from investment grade have increased BB-rated credits’ share of the index to over 50 percent; in prior economic recoveries, BB-rated credits typically made up around 45 percent of the index. At the other end of the credit spectrum, CCC-rated credits now account for less than ten percent of the market, compared to over twenty percent after the Great Recession.
Our constructive view on credit does not necessarily mean smooth sailing in the near term. Most recently, credit spreads have shown greater sensitivity to interest rate volatility, and both the investment grade and high yield markets have given back a portion of their excess returns for the year. If interest rate volatility remains elevated, credit spreads are likely to widen in the near term.
Figure 2: Nonfinancial Corporate Cash on Hand
The next risk event is this week’s FOMC meeting. We expect Chairman Powell to push back against market expectations for an earlier withdrawal of policy accommodation. Most effectively, Powell can provide greater clarity on the thresholds for eventual interest rate increases, while continuing to stress that it is too early to begin discussing a tapering of asset purchases. Failing to do so risks more disorderly market conditions and a meaningful tightening in financial conditions. But given our expectations for strong growth and accommodative policy, we would likely view any spread widening as an opportunity to add risk to credit portfolios in those sectors benefitting from the economy’s re-opening and improving balance sheets.
1. Excess returns in the three rising rate episodes are based on January 5, 2021 – March 12, 2021 for this year’s growth recovery; November 8 – December 15, 2016 for the presidential election episode, and May 21 – July 1, 2013 for the Taper Tantrum. Although rates began rising before May 21 in 2013, we use that date as the start as it was the day of Chairman Bernanke’s Congressional Testimony. In the 2013 and 2016 episodes, excess returns are calculated for less than 50 days to correspond to a peak in the 10-year Treasury yield. Excess returns in each scenario are normalized by the yield change in the 10-year Treasury.
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