Credit investors are fueling a dangerous risk rally built on hopes of easier monetary policy as global growth falters.
High-grade and junk indexes touched fresh records last week while measures of interest-rate risk are hovering near all-time highs.
Angst over the economic trajectory has pushed the stockpile of bonds with below-zero yields to $11.8 trillion. That’s forcing investors into riskier realms to seek out positive returns in credit, confident dovish central banks will help corporate borrowers refinance and neutralize rate risk inherent in long-dated bonds.
All of which points to a big fall if the Federal Reserve and European Central Bank disappoint ultra-dovish expectations.
“The risk of the dream turning into a nightmare is really high,” said Oystein Borsum, chief strategist at Swedbank AB. “It will have to stop. Either the economy will have to improve or risk premiums will widen. You can only have one of the two.”
Government bonds in Europe and the U.S. are flashing recession risks are nigh, as the trade conflict weighs on the industrial cycle. At the same time, spreads on high-grade credit in the euro area trade near 40 basis points below early January highs, after the best start to a year since 2012.
Valuations are “crazy rich,” according to JPMorgan Chase & Co. strategists. But they may become richer still.
Hans Mikkelsen at Bank of America Corp. reckons the global collapse in sovereign yields is leaving investors with little choice but to boost their exposure to corporate obligations. A European trader needs to own three-to-five year continental credit or one-to-three year U.S. corporate debt in hedged terms in order to book a 50 basis point yield, he calculates.
It all helps to explain why money managers are gorging on duration and currency risks across the board. Last week Warren Buffett’s Berkshire Hathaway sold 40-year notes in the Brexit-battered pound, with the price now around 3.8% higher.
One result of this clamor for credit: Corporate bond prices have rarely been more sensitive to changes in interest rates. Modified duration in the Bloomberg Barclays global credit benchmark has jumped this month to almost 6.7 years, a sliver away from the 2017 record. This means that the average bond stands to lose 6.7 cents on the dollar if its yield rises 1%.
It all sets the stage for a pivotal Fed meeting this week with the central bank due to deliver a policy statement and prognosis of economic health. Markets have priced in multiple rate cuts as they expect monetary authorities from Europe to Japan to tackle slowing growth with a new period of easier policy.
JPMorgan acknowledges the reach for yields should stoke demand for risk assets but wall-of-worry situations, from an intensifying trade war to misguided monetary bets, threaten to push up credit premiums.
“Spreads are still towards the middle of the range from the past few years, and look positively expensive if one thinks that a recession could be on the horizon,” wrote strategists including Saul Doctor in a recent note.
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