Why The Credit Markets Matter (And Are Rarely Wrong)

I always receive so many questions about the credit markets and now seems like a great time to dive a little deeper into this topic (with the full understanding that this is not everyone’s cup of tea). Questions that range from “what does it mean when someone says that credit spreads are widening or tightening?” to “what should I be paying attention to in the credit markets?” to “what the heck are the credit markets?”  When you think credit markets, think debt (as opposed to equity markets/the stock market).  The federal government, municipalities, and public companies all issue debt (bonds, bills, notes, etc.) with different maturities and interest schedules in order to finance their operations, capital expenditures, etc.  The consumer is thus the bank in this situation and receives the scheduled interest payments and return of principal at maturity.

So why do the credit markets matter now and how do they relate to the equity markets and the real economy?  First of all, credit spreads have been moving violently in the last week.  As an example, the 10Y moving 45 basis points in a week could be considered maniacal.  It is inherently not a good sign when the Fed Funds rate moves 15 basis points, while at the same time, the 10Y moves 45 basis points. 

A little technical, but one of the best charts to gauge movement in the credit markets is the ICE BofA High Yield Option Adjusted Spread chart.  It basically calculates the spread between an index of option adjusted bonds and a spot Treasury curve rate.  Once again, and as you can see when looking at the chart, the recent spike in spreads is not common.  Second, the very notion of credit spreads widening (basically the yield between corporate bonds and comparable length government bonds) signals that investors need a higher yield or premium to play banker because there is a fear of economic downturn and thus, a higher default risk. This is contradictory to the concept of that in moments of weakness/sell-off in risk assets (i.e. stocks), the investor will flee to risk-free or near risk-free assets (i.e. debt instruments/fixed income).  Although the softening of the tariff policy may have temporarily moved the credit markets off the cliff last week, it served as a reminder that the credit markets matter. 

So, let me finally land the plane here on why it matters.  What was observed last week is that yields have risen in the credit markets juxtaposed to the dollar losing value, which is not the way it generally works and the real fear is that this could indicate an outflow of funds from other countries away from US debt and into the hands of another country.  US assets have always had a safety premium, a growth premium, and a stability premium, but a bond market sell-off makes investors question that the US is actually a safe haven.  It leads to a credit crunch where liquidity becomes a problem, especially if it is paired with an economic slowdown.  My favorite speech (not just because I was in banking for over 20 years and lived through 2008) in the movie/book, Too Big To Fail, is when Former Fed Chairman, Ben Bernanke, said, “I spent my entire academic career studying the Great Depression.  The depression may have started because of a stock market crash, but what hit the general economy was a disruption of credit.  Average citizens unable to borrow money to do anything.  To buy a home, start a business, or stock their shelves.  Credit has the ability to build a modern economy, but lack of credit has the ability to destroy it, swiftly and absolutely.” 

To alleviate some fears, after 2008, banks are so well capitalized (30%+ in reserves) that a run on banks (at least the systemically important banks) is almost impossible, but the point is that credit markets certainly matter and they are rarely wrong.