Corporate Treasury Weekly: credit markets normalise as inflation creeps into more discussions

27 May 2021

Giles GaleHead of European Rates Strategy

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Breaking down trending trades & themes to help corporate treasurers get ahead of the latest issues shaping markets

Credit markets are starting to normalise as expectations of higher inflation feed through to bond yields and swap prices (which are both rising), but we don’t see this as especially concerning. Investors are becoming more selective, but they also have cash to deploy and the need to deploy it. At the same time, we see inflation increasingly creeping into an array of discussions.

  • US bond yields are still the frontrunner among broadly higher global rates: Comments made last week by US Federal Reserve Vice-Chair Richard Clarida suggest – at least to us – a greater appreciation of rising inflation expectations and slightly less dovishness than markets seem to believe. We still think the Fed will use the September meeting to signal its intentions to reduce quantitative easing or QE (starting in 2022), employment & inflation data permitting. But if the next inflation data is firm, it may be possible that this is accelerated, which means higher bond yields sooner than expected as investors look to get ahead of the shift.
  • The European Central Bank (ECB) looks less likely to taper QE in June: Rising US yields may put upward pressure on global rates, but in the Euro Area, the ECB now looks less likely to reduce its rate of QE than we thought just weeks ago – partly due to a rise in yields, and the risk of fragmented financial conditions. We suspect there may be pent up demand for bonds into the summer, especially if the ECB maintains its current QE policy.
  • Drags on inflation – like tepid wage inflation & stronger Pound – may keep UK yields in check near-term: Although the UK economic recovery is gathering pace, which is positive for growth and puts upward pressure on yields, underlying wage inflation remains tepid – even as employers struggle to fill vacancies. A stronger Pound could also be a moderate drag on inflation. In the short term, there remains huge uncertainty around monthly inflation readings throughout the summer as spending on pandemic-affected items (energy, travel, clothing) continues to normalise.
  • Bitcoin’s recent volatility doesn’t mean credit & equity valuations will come under pressure: Bitcoin was significantly more volatile last week (even by cryptocurrency standards), but despite its 35% fall we don’t anticipate any contagion to other markets. Bitcoin’s positive association with stock prices is largely spurious and mostly due to the fact that both have been rising.
  • Stronger growth is positive for commodity-linked currencies but negative for the US dollar: The stronger global growth outlook and the positive backdrop for risk assets is driving FX, which means a weaker US dollar and stronger commodity-linked currencies (think Aussie Dollar, Canadian Dollar). We also think lower levels of uncertainty in the broader UK economic outlook – perhaps the lowest levels in quite a long time – is positive for the Pound.

Inflation creeps into more discussions

Inflation is clearly a talking point for many, creeping its way into a broadening array of discussions and in slightly different ways across geographies. From a fundamental perspective, European firms are often concerned about cost pressure (via inputs but also finance) on margins due to limited pricing power, especially where tied into long-term contracts. But UK firms, on the other hand, have been more focused on how to protect themselves from a strengthening Pound.

Bond spreads are widening as investors get more selective

We are seeing some credit spread widening and new issue premia for some bond issuers as expectations build around greater inflation pressure and higher rates. We also see investors becoming more selective, and with many corporates sharing the same underlying concerns as their financiers (rising rates, higher inflation) some firms are starting to accelerate their fundraising plans. Overall, we think spread widening will be limited as investors have cash to deploy – and the need to deploy it – and we see this as part of a broader normalisation of credit markets.

The latest Bank of England (BOE) Credit Conditions Survey, which helps paint a picture of why corporates are borrowing, lends some weight to the view that a rise in capex waits in the wings. The latest reading shows a pick-up in funding for acquisition purposes, already at multi-decade highs, alongside a very sharp rise in borrowing to fund capex – the highest levels seen since 2014.

UK corporate borrowing: capex vs. M&A

Sources: Bank of England, NatWest Markets

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