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The surprisingly chilled bear market — credit edition

FTAV last week wrote about how, given the scale of the downturn, the equity bear market has been remarkably tranquil. Belatedly we’ve come across some interesting further points on the surprisingly orderly credit markets.

Obviously, credit markets have also puked this year. But it has been a controlled, strategic, the-day-afterwards discharge rather than a messy post-kebab 3am accident. As Calderwood Capital put it more decorously in a recent Popular Delusions report, credit is priced “too tight to buy, but too wide to short”.

The becalmed Vix index is a good proxy for how orderly the bear market has been (despite the UK’s best efforts). Calderwood points out that credit-default swaps have told a very similar tale — with some idiosyncrasies.

Here’s the US junk bond CDS credit spread index, which remains well below its 2008, 2011 and 2020 peaks, and the shape of the CDS curve, which tends to invert as markets freak out about a rash of near-term defaults.

You can also see the calm in the difference between CDS indices and the single-name prices of their individual constituents. The liquidity of single-name CDS has atrophied over the past decade, so the “basis” to the indices tends to gap out when markets are turbulent.

As the Calderwood charts below show, the US index-constituent CDS basis is far more muted than during 2008, 2020, and even 2014-15 when energy prices crashed. And weirdly, in Europe the basis is actually negative now — the less liquid single-name CDS are trading at a tighter spread than the more traded and diversified.

There are several good explanations for the odd credit market calm. The biggest is naturally that economic growth remains for the most part strong. That many borrowers have locked in low fixed rates obviously also helps, and the European CDS basis anomaly might be explained by local investors overpaying for economy-wide tail risk hedging.

The question is whether the current orderliness will prove as “transitory” as inflation, and eventually morph into a systemic event of some kind. It seems everyone assumes this is inevitable, with the UK’s LDI debacle causing a scramble for other obscure pockets of dangerous leverage that might blow up more than just the gilt market.

Calderwood doesn’t discount this possibility, but makes the very pertinent point that every bear market and economic setback is as unique as a snowflake: deep recessions can cause minor market ripples, just as major bear markets can be coupled with shallow recessions.

. . . Such explanations imply that 2022 has been somehow aberrant, and that the crash is still to come. But maybe it isn’t. What if this economic cycle will be less evenly distributed, or more redistributive than prior ones? Could it be that some parts of the economy benefit at other’s expense, and to a greater degree than we’ve seen for some time? This would show up in lower aggregate volatility across the economy.

. . . Drawdowns have come in different flavours, and there have been plenty of serious macro disturbances in history — including deep recessions such as that of the early 1980s — which have not been seen as ‘systemic’ crashes. Indeed, the balance sheet liquidity mismatches which have surfaced in crypto, UK pensions or US mortgage REITs have not caused contagion and might be taken as indications that financial connections are not as deep, and so correlations not as high, as they were in 2008.

It’s not hard to see parallels today with both the 1970s (OPEC then, Russia today) and the correction of the 2000 tech bubble (dotcoms then, FAANGs today). In each case, the effects of the ‘shock’ were unevenly distributed, and in each case, realised vol didn’t meaningfully breach 40. Unfortunately, this doesn’t mean that the current ‘redistributive’ downturn won’t become a more highly correlated one in the coming months.

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