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.
He concludes with a look at fundamentals which are troubling:
With defaults picking up in the commodity space, incredible stress in some individual non-commodity high yield issuers, a wave of downgrades looming and now the Fed’s revisions to near-term forecasts, we wonder how long asset allocators will continue to ignore both the weak macro as well as poor micro credit environment and feed money into high yield. Chair Yellen told us today that inflation is likely to remain weak and dollar strength will continue to cause headwinds. This latter admission is particularly interesting to us. If a strong dollar persists in 2016 corporate earnings hurt by FX exposure are unlikely to improve meaningfully. Couple this dynamic with ever increasing write offs and impairment charges (even ex-Energy) and the recent rally looks to have limited staying power in our view.
For now the dollar is weaker, however that is only until the ECB and BOJ intervene once again to crush their currencies - because as a reminder while China wants a weaker dollar, both Japan and Europe want precisely the opposite - which we believe is imminent.