If You Want to Understand Overall Credit Spreads, You Have to Have Both a Macro and Micro View

If you want to understand overall credit spreads you have to have both a macro and a micro view. The macro view looks at the business cycle and the chance of default for risky assets based on economic growth. The micro view looks at the credit supply coming to market, the demand for loanable funds at any time, and the structure of deals. The macro focuses on credit risk expectations and the micro will be more centered on the flow of funds. A macro-micro framework helps focus our interest in actual and perceived credit dislocations.

There is growing interest is the strong widening in the LIBOR-OIS spreads as measure of short-term financial credit risk. Let be clear that the dynamics of LIBOR are complex; a concentrated dealer community, a disperse set of global users, a multitude of strategies and uses, and a history of manipulation. There is no simple explanation for spread changes and a spread dislocation may just as easily represent a structural change as a macro expectation change. That said, LIBOR-OIS spreads have widened along with short-term corporate spreads and the TED spread. Credit risks are being repriced.

Macro credit risk should be repriced higher given higher equity and bond volatility and a potential slowdown in earnings later this year, but the current spike is more related to structural issues. However, the spread widening may be unrelated to bank risk. Financial conditions have tightened, but the absolute level is not suggestive of high spreads.

What is an issue is the global flow of funds. The repatriation of dollars held offshore, an increase in Treasury bill supply and a tightening of dollar swap lines are all impacting short rates on the margin.

Markets are adjusting under what we call the Fed ‘s new period of quantitative tightening (QT). What is the most powerful effect may be the shortage of dollar funding for global financial transaction. For investors who have following the research and commentary of the Bank of International Settlements (BIS), the demand for dollar funding is an ongoing structural problem given the amount of dollar denominated debt. This is not going away and a shortage of dollar will force spreads higher.