The level of fear among the managers of funds that buy investment-grade and high-yield debt has sunk to its lowest level since 2014, according to the Bank of America’s March survey of fund managers. “The most notable change in our fresh survey of U.S. credit investors is that most concerns have declined notably from December and January,’’ write analysts at the bank. You’ll note that this drop in fear corresponds to the Federal Reserve’s perceived about face on interest rate increase in 2019. The U.S. central bank will not raise interest rates even once in 2019, according to pricing in the Fed Funds Futures market.
This, I’d note, is one of those contrarian indicators. In other words it’s not a good sign that fear in the credit markets has plunged to a five-year low.
That’s because credit market history and credit market theory says that it is precisely at this point–when actual credit risk is rising and credit risk standards are falling–that financial markets get themselves in deep, deep trouble and frequently trigger what is known as a Minsky Moment.
The credit cycle works like this: After a long run of good news on the economy and on debt markets, investors start to forget the lessons of the last bad time for the markets. Even as the amount of debt issued rises–which it’s doing right now in both the Treasury and corporate debt markets–investors and traders are ever more willing to overlook problems in their search for yield. The covenants written into bonds to protect buyers get loser; companies that couldn’t access the markets except on onerous terms now find investors eager to buy their debt offerings at modest premiums to the “risk-free” Treasury yield. Banks loosen their credit standards to chase market share in the debt markets. Government regulators pull back on their scrutiny of financial companies and Congress rewrites legislation to favor “regulation light” approaches to the financial system.
Which all works until it doesn’t. It doesn’t take a recession, necessarily, to produce the turn in the cycle–although a slowing economy does serve to make debt investors suddenly look to see who can pay what back to whom. It does require a loss of the faith that everything is okay and that getting paid less for risk is reasonable in the current situation. Once that idea starts to make headway, lenders of all sorts start to ask for a bigger premium to take on risk. Or they tighten standards for making a loan or buying debt. A few companies might at this stage experience a problem in paying back debt. Which leads to a further demand for higher premiums and a pull back, here and there, by lenders who aren’t willing to lend as much or at all under these new conditions. If that pullback from the credit markets gets severe enough, we reach a Minsky Moment, named after U.S. economist Hyman Minsky.
Minsky’s major insights were that credit markets are inherently unstable and that the top of the cycle when too much money chases debt under too generous terms has a tendency to evolve into a downdraft where lenders refuse to lend at any premium. (At which point one hopes that a central bank or two will have the balance sheet room to pick up the lending slack.) That lack of credit in the normal credit channels can then freeze an economy as lenders re-instate the risk control measures that they relaxed at the top of the cycle.
I can see evidence now of most of the conditions that describe the top of the credit cycle. For example, Congress and financial regulators are pulling back on stress tests of major financial institutions.
If the U.S. economy continues to slow–and even if we don’t get a recession in 2020–I can see the conditions for a credit contraction in 2020. I’d suggest that investors and traders begin to lighten up their exposure to riskier debt now. I know that’s a contrarian action but that’s what contrarian indicators are for.
I’ll have a credit cycle sell for you tomorrow.
