From the interest rate race to rating problems
In a hike that ends in a recession, rates typically peak earlier than credit spreads. More precisely, usually rates peak around the time of the penultimate Fed hike. We believe we are now crossing the valley that separates the two peaks. Rates have started to fall and may have peaked in some markets, while inflation appears to be slowing down. Credit spreads have also jumped since mid-October but are set to tighten as markets start anticipating a recession which would harm the health of businesses.
Gradually the recession gains space and is increasingly integrated into the general outlook, increasing market dispersion. Lower quality credit should experience higher default rates, while the higher end of the market could benefit from lower rates and a race for quality.
Once the recession is fully priced in and the spread cycle is over, it will be advisable to adopt a decidedly long positioning, even in the high yield universe. Typically, the reversal occurs well before default rates peak.
Con the increase in the supply of European government bonds, we expect a further narrowing of spreads on euro swaps. Given the point in the cycle we are in and given that swap spreads weigh heavily on the total spread of the euro investment grade segment, we look forward to a moderately long position in investment grade markets in Euros as we tread very cautiously on other sparsely-evolved markets.
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