Market Insight – August 2024
The market turmoil sparked by the disappointing July jobs report left a mark on US rates markets, although rates have been retracing modestly higher in recent days. Interest rate futures markets are pointing to a series of policy rate cuts in the coming months, presumably to ease economic conditions and forestall a recession.
Interestingly, despite the recent drama in the US rates and equities market, credit markets are not signaling significantly greater anxiety. In previous notes, we have referenced two data series from the Federal Reserve Bank of New York that are linked to credit market conditions. These are the FRBNY Recession Probability Index and the FRBNY Corporate Market Distress Index. While there are numerous other metrics that cover these topics, we like these because they are based on snapshots of actual market conditions, and therefore are reflective of the evolution of actual market conditions over time. The Recession Probability Index uses the slope of the yield curve, or its “term spread,” to calculate the implied probability of a recession in the United States twelve months ahead. Here, the term spread is defined as the difference between 10-year and 3-month Treasury rates. Its most recent reading, taken before the July employment report, signaled a 56.5% probability of recession one year ahead. While we suspect this will increase following the July jobs data, the calculation mechanics of the index suggest it will be late August before any impact is reflected in this index.
The second indicator, the Corporate Market Distress Index, uses a variety of indicators to measure dislocations in the primary and secondary corporate bond market. Based on its most recent reading (July 26) corporate credit market distress was near its lowest level in over two years (also Exhibit 1).
Consistent with the lack of credit market distress, credit spreads on high grade credit indices have generally been trending lower since fall of 2023, before recently nudging slightly higher. This is evident in credit spreads on broad-based high grade indices such as SOFR Academy’s FXI (Financial Conditions Credit Spread Index) or the Bloomberg US Corporate 0-5 Year index (Exhibit 2). While the Bloomberg 0-5y US corporate and the FXI index essentially track the credit spreads of same underlying market, the FXI is based on actual market transactions while Bloomberg uses a combination of market transactions and model-based pricing. This dynamic results in FXI being more sensitive to changes in credit spreads.
“Consistent with the lack of credit market distress, credit spreads on high grade credit indices have generally been trending lower since fall of 2023, before recently nudging slightly higher. ”– Alex Roever, CFA, Senior Advisor, SOFR Academy
Financial conditions may have tightened, but are they tight?
The credit markets have reacted to the July Jobs data, but the credit spread moves have been small relative to the changes in equities and US Treasury yields. In the immediate wake of the jobs report, credit spreads on fixed-rate high grade credit indices widened but to varying degrees. Exhibit 2 compares credit spreads on the SOFR Academy FXI (Financial Conditions Credit Spread Index) or the Bloomberg US Corporate 0-5 Year index. These two indexes effectively cover the same market but have had different spread performance in recent days. The reason for this divergence lies in the purpose and construction of these indexes.
The Bloomberg indices are designed to measure total returns on a market or defined market segment. In doing so, they consider the performance of every bond qualified for inclusion. Of these constituents, some may trade daily, and others infrequently. As a result, index valuation requires a combination of actual trade prices and model-based prices for non-traded components. In contrast, FXI (and the SOFR Academy AXI) valuations are based on liquid subsets traded securities. The result is an index reflecting the most liquid portion of the underlying market. The composition of the actual underlying securities can shift from day to day, depending on which eligible securities trade or don’t trade.
Following the July jobs report the spread levels of these two indexes diverged modestly. Based on FXI, the core of the market is reflecting only modest impact thus far. In contrast, the broader market captured by the Bloomberg index has seen spreads widen, suggesting that trading conditions for some segments of the index have become more challenging since the data release. For instance, the Bloomberg Index is more likely to have less liquid and less traded credits that are more affected by a deterioration in market demand.
While the Bloomberg 0-5y US corporate and the FXI index essentially track credit spreads of bonds in the same underlying market, Bloomberg is a broad-based index that measures the performance of a whole market or segment. These kinds of indices are inclusive of a whole market or market segment, which can require the use of both actual prices of traded securities and modeled prices for untraded index members.
In contrast, FXI (and AXI) measure value based on traded securities instead of reflecting the performance of all the potential index constituents. And the composition of that subset traded eligible bonds can shift from day to day. The result is that AXI and FXI reflect the liquid core of the high grade market.
In times of market stress, the different pricing dynamics tend to result in spreads on the Bloomberg Indices moving more than on FXI. That said, when bond market liquidity deteriorates markedly (such as the US regional banking crisis in March 2023) both indexes tend to move together.
The same observation and comparison can be made for credit indexes covering just financials. Exhibit 3 illustrates spreads on both the Bloomberg US Financial Institutions Index and the SOFR Academy Across-the-Curve Credit Index (AXI). In this comparison, there is a wider spread diversion in large part because this Bloomberg index covers financials with maturities out to 30 years, while AXI only goes out to five-years. Consequently, the spread duration of AXI is lower. Even so, there’s a strong relationship in spread performance over time. Until the July Jobs report both indices were on a steady narrowing trend for the past year. Like Exhibit 2, the Bloomberg index is broader, reflecting greater sensitivity to the recent data surprise.
Another relevant comparison of credit dynamic involves the evolution of yields in the floating rate note market. Exhibit 4 compares the yield on the Bloomberg High Grade Floating Rate Note Index relative to a combination of the SOFR Academy AXI Index plus SOFR (note: as benchmark quality credit spreads both AXI and FXI have been designed to function as credit supplements to SOFR, see our Frequently Asked Questions). In this case, yields on both the Bloomberg FRN Index and the AXI+SOFR combination have shown little reaction to recent events. This contrasts with the broader fixed rate market where spreads showed some widening. One possible explanation for the difference in fixed and floating markets is that all-in yields on fixed (rate + credit spread) can be slow to react when treasuries rates drop suddenly, pressuring spreads wider. In the case of FRNs, the underlying rate (SOFR) was unaffected, leaving less pressure on the credit component.
Interpreting the impact of market events benefits from a broad view of market reaction
In this note, we have covered the reaction of US credit markets to a significant economic data surprise. Our analysis used data from both broad-based total return indexes (Bloomberg) and indexes focused on the more liquid segments of the markets (SOFR Academy AXI and FXI). We also discussed how some structural differences in index construction influence index behavior. Combining the views from both types of indexes provides a more complete understanding of bond markets in motion.
Alex Roever, CFA, is a Senior Advisor at SOFR Academy ([email protected]).
This note is provided for informational purposes by SOFR Academy, Inc. (SOFR Academy), an economic education and market information provider. This note is not designed to be taken as advice or a recommendation for any investment decision or strategy. Readers should make an independent assessment of relevant economic, legal, regulatory, tax, credit, and accounting considerations and determine, together with their own professionals and advisers, if the use of any index is appropriate to their goals. Neither the Invesco / SOFR Academy USD Across-the-Curve Credit Spread Index (AXI), nor the Invesco / SOFR Academy USD Financial Conditions Credit Spread Index (FXI) are associated with or sponsored by the Federal Reserve Bank of New York or any regulatory authority. Additional information about SOFR Academy, AXI and FXI can be found here.
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