What is truth?

In a note that may have been quite prescient, BofA’s HY strategist Michael Contopoulos released a note last night titled “Fed acknowledges global growth concerns… again”, in which he said that “we have to admit; today’s dovish comments by Yellen took us by surprise” and adds that “although the market’s initial reaction was positive, we think the longer run impact of a very dovish message is bad for risk assets. In fact, we’re a bit amazed by the initial response from high yield today.”

The catalyst that clued Contopoulos to what the Fed really meant was to be found in the reaction of financial stocks:

We also believe it is telling that bank stocks moved significantly lower after the rate decision. Though the price action in banks makes sense – a lower for longer rate environment and slower economic growth is not a positive scenario for financials – typically the moves in bank equity and high yield spreads are very well correlated (-48%). In our view the challenging bank environment is a canary in the coal mine for high yield. As financial volatility increases, bank earnings decline, and unease about the global economy heightens, banks pull back on risk and lending. Note the latest Fed survey on lending standards as a prime example of declining risk tolerance of loan officers.

Judging by the market’s performance this morning, Contopoulos was correct. And if he was correct about that, then he may well be correct about what happens next, which is as follows:

Given the apparently weaker consumer (retail sales, nonmanufacturing ISM), the poor Q4 earnings season, and problems abroad, the acknowledgment by Chair Yellen of stresses in financial markets creating tighter financial conditions should have created renewed fears of a growth slowdown in the US, in our view. In fact,the last 2 times the Fed indicated global risks to the domestic economy, while holding rates steady, were at the September meeting and January meeting. And in both cases HYG declined 4.5% and 4% over the next 13 days (Chart 1). Although we don’t know if the same reaction will occur after this meeting, we are convinced that our bearish view on high yield continues to hold merit.




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