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The Fed’s sugar rush rally

The Fed’s sugar rush rally

05-07-2019 | 月次アウトルック

When the Fed starts cutting rates, it is easier to be long 2-year Treasuries than credit, says Global Macro team co-head Jamie Stuttard.

  • Jamie Stuttard
    Jamie
    Stuttard
    Head Global Macro Fixed Income Team

Speed read

  • Credit markets are seen remaining positive in the short run
  • The relief is expected to be brief though – just like a sugar rush
  • In these kind of rallies, 2-year Treasuries perform better than credits

The US central bank is considering cutting rates as ‘insurance’ against a weakening global economy, having raised them nine times since 2015 to the present range of 2.25-2.50%. Cutting rates usually gives markets a short-term boost – akin to a sugar rush when consuming a sweet drink – according to a research paper by the Robeco Global Macro team. As with a sugar rush in humans, history suggests the effect may be short-lived, the team says.

A short-term boost

“In 2001 and 2007, credit spreads widened out sharply before the Fed cuts ahead of recessions. After the first Fed rate cut, credit spreads tightened for three to six weeks in both periods as US equity indices reached fresh all-time highs – giving a brief window to sell into strength, before spreads resumed their cyclical path,” Stuttard says.

After the brief sugar rush is over, credit spreads have widened in the long run in most periods when the Fed has cut rates. There have only been a few exceptions, such as in 1995, he says. So, the key is to distinguish between a ‘trading horizon’, typically three to six weeks, and an ‘investment horizon’ of more like 2-4 quarters.

Stuttard and his team analyzed daily performance before and after the first Fed cut of each cycle over the last 23 years.

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Rate cuts and Treasury yields

The Fed has only initiated three easing episodes over this period (1998, 2001 and 2007). If we go back a bit further and take three decades, the Fed started cutting rates on five occasions: in June 1989, July 1995, September 1998, January 2001 and September 2007.

Stuttard looked at USD credit spread levels 5, 22 and 64 days before and after the day of the Fed move (T+0). These correspond to approximately a week, a month and three months before and after T+0. “The idea is to help understand the short-term trading reaction around the first Fed cut. We also looked at 2-year US Treasury yields.”

So, how much did 2-year yields fall from their peaks to the first cut? Stuttard says the most striking finding is that the fall in 2-year US Treasury yields accelerates downwards both into the first rate cut and afterwards.

Two-year UST yields (%) before and after the first cut.
Source: Bloomberg, Robeco calculations

In each one of the last five cycles that the Fed cut rates, 2-year Treasury yields fell by 100 bps or more in the three months before the first cut. On average, 2-year yields have fallen by 156 bps from their maximum level before the first Fed cut to the T+0 of the Fed cut itself. In 2019, US 2-year Treasuries have fallen 64 bps in the last three months. However, they’ve fallen 112 bps since the yield peak at 2.96% in November 2018.

And now for credit

So much for Treasuries. What happened to credit in and around Fed cuts? “We used BBB credit, because we think it is the fairest consistent measure of credit quality over time. In the period before the first cut we see that credit spreads widened materially in the three months before T+0 in 2001, 2007 and 1998. In fact 1998 saw the sharpest widening.”

There is of course a specific reason for that. The ‘insurance’ bought by the Fed was after the fire of the (LTCM/Russia) event had started. “Normally when you insure something, you’re supposed to buy the insurance first before the bad thing happens,” Stuttard notes.

Performance of USD BBB OAS before and after the first cut.
Source: ICE BofAML, Bloomberg, Robeco calculations

Yet in 2019, over the last three months, the market has barely widened at all. “If history repeats (it rhymes rather than repeating and the sample size is small, but still…), it might suggest that either the Fed cut isn’t due yet (there’s no recent audible alarm bell yet from credit markets or the alarm bell was 2018) and credit spreads are about to widen a lot – and then we’ll get the first cut!”

What happened after the first cut?

Stuttard’s analysis shows three different paths in the historical precursors. Spreads initially:

  • Widened in 1998 before recovering to flat, as there was no recession
  • Tightened in 2001 for about six weeks, before resuming a widening trend over a more strategic investment horizon in late 2001 and in 2002
  • Tightened again in 2007 for one month. But that was all the rally lasted (the tight was reached within four weeks amid a new all-time high in US equities). We all know what happened next.
So, with the exception of 1998, spreads indeed went a bit tighter straight after the first cut of the cycle – for 3-6 weeks – before resuming their cyclical GDP-driven path. We see the same pattern in USD IG and in USD HY. “It seems sugar rush theory is intact,” Stuttard concludes.

There is no 1998-style panic in markets today (there is no fear of Wall Street brokers going bust due to a major G8 sovereign default plus the failure of the world’s most iconic hedge fund). Instead, there is a seemingly consensus belief across much of the buyside and sellside that central bankers have once again got their backs and that an interest rate cut should be treated as a chance to establish risk positions.

“We prefer to be contrarian, and if we see a sugar rush rally extending too much further, we prefer to reduce risk when the bids are still there,” Stuttard says.

Meanwhile at the European Central Bank, incoming Chief Economist Philip Lane has in July echoed outgoing President Mario Draghi’s hints that the ECB is warming up to another round of QE. If the Corporate Bond QE program (CSPP) is reactivated, this can be beneficial for EUR non-financial corporates. But for longer-term global direction, the actions of the Fed are likely to be key.

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