- The reflation trade is set to continue as interest rates drift higher – HY looks likely to outperform IG. Notably, the recent spread widening combined with strong PMIs has pushed the valuation of iTraxx crossover (European HY) into positive territory for the first time in six years.
- The share of credit purchases jumped to nearly 20% of the total ECB QE amount in January, suggesting that this technical tailwind for EUR credit spreads could persist into year-end. On the other side of the pond, the latest spate of US HY ETF outflows has been as severe as in March 2016 or the summer of 2015 but prices have been relatively resilient.
- Historical evidence from previous VIX volatility index spikes suggests that a widening in credit spreads over a three month horizon is far from a given but at this juncture we can expect a mild widening.
The reflation trade strikes back (and is set to run further)
Recent market volatility aside, the trading pattern in January has been consistent with the reflation trade. This means tighter spreads amid higher rates but with investment grade (IG) total returns taking a bigger hit than high yield (HY) (Exhibit 1) due to duration. The 1.4% total return differential of HY over IG in the US year-to-date aptly demonstrates the higher spread and lower duration advantage of HY. The differential was actually 2.4% on 2 February, the last trading session before the VIX flash-crash on 5 February.
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