Rates: Warning signs that equities might have it all wrong

The rates (or bond) market has a better record than most at discounting the future. For example, as the great financial crisis unfolded, bond yields fell for months before equities finally got the message that things were looking a bit ropey. And there are many other examples. Not that the bond market is perfect, but it has typically done a much better job than equity markets.

Equity market valuations are a function of forward earnings, typically heavily influenced by the immediate year ahead, through corporate guidance. Beyond that, things get quite fuzzy. And even with prospects for 2020/21 far from certain, equity markets are looking into that fuzziness and are tending to see more positive than negative shadows.

The bond market discount is quite different.

Typically when the 5yr is rich, it signals an imminent fall in yields. It does not signal a bear market for bonds. This is a rates market that discounts maintenance of low rates

This is being partly driven by a Federal Reserve that has been unwaveringly apprehensive on the future. That has anchored the 2yr rate at sub-20bp, literally for months now. And the prognosis is for it to remain there. The 10yr did manage to jump to 90bp a few weeks back as the risk-on mood became almost persuasive, but it has since drifted back to the magnet of 60-65bp.

The talk now is of a potential test of the all-time low at 54bp hit in early March as the crisis really took hold.

Either way, one thing is for sure. This bond market does not look anything remotely like a bear market. We assert that not purely based on the level of yields, but more on the structure of the curve. Specifically, we note the richness attached to the 5yr area (a combination of the 2yr and 10yr returns a higher yield than the 5yr outright). This is an important signal. The 5yr area is not as slavish to the fed funds rate futures as the 2yr is, and tends to have a better nose for what is coming down the line than the 10yr does (its nose, is too long).

Typically when the 5yr is rich, it signals an imminent fall in yields. It does not signal a bear market for bonds. This is a rates market that discounts maintenance of low rates.

Very often credit spreads correlate with equity markets. As equity markets bottomed in late March, credit spreads peaked, just as the VIX did.

Here we find that the current theoretical default rate is in the area of 8% for one year. How does this compare with the great financial crisis? Well through 2008/2009 cumulative defaults were in the region of 15%.

The USD high yield CDS hit almost 900bp at the extreme, before falling back to a low in the area of 425bp. That is still above the pre-Covid levels in the sub-300bp area, but well below the explosive highs. That said, in the past month the spread has drifted wider by some 100bp, to the 530bp area.

So what does a 530bp spread tell us?

Well the spread itself is a repercussion for being in a default-prone asset class. It provides compensation for taking business risk above and beyond the systemic risk-free rate. By the same token it can be used to back out a default rate expectation, and in fact as the spread changes over time, so too does the implied future default rate.

We find that the current theoretical default rate is in the area of 8%. The low was 7%, but it is in any case well down from the 14% default rate that was being predicted when spreads approached 900bp.

How does this compare with the great financial crisis? Well through 2008/2009, cumulative defaults were in the region of 15% (over two years). Typically default rates are quoted over a 12-month period. Here it was 5.5% in 2008 and 9.4% in 2009. The cumulative measure overstates when compared with a one year measure, but provides a deeper impression, and helps to fully contextualise the current implied default expectation.

We've been impressed with the fact that the Nasdaq is up some 10% year-to-date. But we should also remember that the rally seen in equity markets since end-March still leaves most bourses well down year-to-date. The Dow Jones is now down some 10% and the likes of Spain's IBEX is down over 20%.

So, while equity markets have turned in a remarkable improvement since end-March, absolute valuations are still stressed. The fact that rates markets have not bought into the relative optimism remains an underlying drag.