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Why Bond Traders Have No Idea What's Going On

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Draghi shot his ‘bazooka’ today and the initial reaction from investors is telling, according to BofA's Michael Contopoulos. The price action in markets (equities down, US rates higher, strength in the Euro) suggests that investors focused more on the signaling of no further interest rate cuts than on the reductions in three key interest rates and the additional bond purchases. In BAML's High Yield Strategists' view, this bolsters their case that markets have essentially lost confidence in the ability for central banks to stoke growth and inflation, and although they feel the initial selloff was perhaps a bit too severe, they find it leaves Draghi in a bit of a bind.

 

Clearly European growth and inflation is a severe concern. China exports have slowed and deflationary pressure in the Eurozone is causing unprecedented ECB action with consequences we have yet to likely appreciate. In fact, as we sit back and look at the macro landscape, we see very few reasons to be excited by today’s action or any development since the February 11th market lows.

 

As rates have plummeted globally, over $5tn in Japan alone, bank lending has failed to pick up. In fact, NIRP has coincided with an increased savings rate in Japan and Draghi today acknowledged the problems negative rates would have on financials. Furthermore, we question the rally in high yield, which was initially a consequence of overdone recession fears creating a short squeeze once the manufacturing sector showed signs of life and commodities began to rally. As yields fell, retail demand swelled, as flows tend to follow returns, and unfortunately, many investors have been left reluctantly buying bonds, ETFs and CDX HY to offset the increase in cash (Chart 1).

 

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What we find so concerning is that fundamentals haven’t really changed. The increase in oil prices does little to nothing to help the financial health of the energy space and with redetermination on its way we think energy bonds could face more pressure later this spring. Furthermore, the retail money that chased returns is likely flighty, and potentially doesn’t quite appreciate that 50% of the market currently trades at an average of 300bp while 50% of the market trades north of an average of 1100bp. For context, the market lows of this cycle were 330bp. Though this bifurcation isn’t abnormal, we do think the higher yields optically create a false sense of broad market cheapness. The correlation with oil prices is a phenomenon we find very troubling (Chart 2).

 

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By obsessing over the daily price movements of commodities, the market is clearly not paying attention to a poor earnings backdrop, revenue that is disappointing, leverage that is high, and capital markets that are difficult to tap. We think this is a very big mistake.

 

And although the additional bond purchases likely help to limit any further widening in European corporate spreads, and in fact likely cause them to rally, we are unconvinced the impact on US corporates will be long lasting. The European bond market is quite small, just $1.6tn in face value. It is hard to imagine a massive flow of capital to US high yield because of the additional buying.

 

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