Credit Rally Defies Rotten Fundamentals After Central Bank Buys

(Bloomberg) -- Credit markets have rallied strongly this month, despite an economic slump which slashes earnings even as companies take on more debt. Central banks saying they’d buy corporate bonds helped crush credit spreads, but they can’t resolve fundamental underlying issues.

“The gap between markets and economic data has never been larger,” Matt King, global head of credit strategy at Citigroup Inc., wrote in a note Wednesday.

High-grade debt markets are on track for the best total return since 2008. Meanwhile, bond issuance is at a record high, just as the U.S. economic expansion ends with the deepest recession in eight decades.

According to Citi analysis, European credit spreads are tighter than what a plunge in the regional Purchasing Managers’ Index would imply. U.S. equities are also out of whack with U.S. economic data, the analysis shows.

According to King, $5 trillion of prospective central bank buying is “igniting FOMO among investors,” referring to fear of missing out. This has made markets look expensive even in the most optimistic credit default scenarios, he said.

Unlimited liquidity from central banks can postpone debt problems but won’t fix them, according to Citi, which sees a V-shaped return to normal as extremely unlikely. The coronavirus challenge is more about solvency than liquidity, it said.

Sovereign, corporate and household credit quality are “taking a very big hit,” which rises almost exponentially with the duration of lockdowns, according to the bank.

“Expense cutbacks, although individually rational, risk being collectively disastrous,” King wrote. “Expect evidence of this to emerge gradually, then suddenly, in coming weeks.”

At best, debt overhangs and rebuilding of buffers like excess portfolio or balance sheet liquidity will have long-lasting deflationary consequences. At worst, “defaults will feed on each other,” said Citi in the note.

As economies worldwide continue to founder, leverage levels are creeping higher, and credit rating downgrades are happening at an ever faster pace.

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