Low VIX and Thin Spreads Could Be on Thin Ice

WEEKLY MARKET OUTLOOK FEBRUARY 23, 2017 CAPITAL MARKETS RESEARCH Moody’s Analytics markets and distributes all Moody’s Capital Markets Research, Inc. materials. Moody’s Capital Markets Research, Inc is a subsidiary of Moody’s Corporation. Moody’s Analytics does not provide investment advisory services or products. For further detail, please see the last page. Low VIX and Thin Spreads Could Be on Thin Ice Credit Markets Review and Outlook by John Lonski Low VIX and Thin Spreads Could Be on Thin Ice. » FULL STORY PAGE 2 The Week Ahead We preview economic reports and forecasts from the US, UK/Europe, and Asia/Pacific regions. » FULL STORY PAGE 5 The Long View Check our chart here for forecast summaries of key credit market metrics. Full updated stories, “First-quarter 2017’s US$ high-yield bond issuance may expand by 49% annually from Q1-2016’s low base,” begin on page 14. » FULL STORY PAGE 14 Ratings Round-Up by Ben Garber and Njundu Sanneh Aggressive Financial Policy Leads to Downgrades. » FULL STORY PAGE 19 Market Data Credit spreads, CDS movers, issuance. » FULL STORY PAGE 21 Moody’s Capital Markets Research recent publications Links to commentaries on: Rates, France, demography, boom, Japan, reform, India, Turkey, risk, UK, deregulation, potential, BAC, optimism, Portugal, DB, revisions, outlook, US, great, China. » FULL STORY PAGE 25 Credit Spreads Investment Grade: Year-end 2017 spread to exceed its recent 120 bp. High Yield: After recent spread of 384 bp, it may approximate 460 bp by year-end 2017. Defaults US HY default rate: after January 2017’s 5.8%, Moody’s Credit Policy Group forecasts it near 3.7% by 4Q 2017. Issuance In 2016, US$-denominated IG bond issuance grew by 5.5% to a record $1.411 trillion, while US$-priced high-yield bond issuance fell by -3.5% to $341 billion. For 2017, US$-denominated IG bond issuance may rise by 1.6%, while US$-priced high-yield bond issuance may increase by 7.5%. Click here for Moody’s Credit Outlook, our sister publication containing Moody’s rating agency analysis of recent news events, summaries of recent rating changes, and summaries of recent research. Moody’s Capital Markets Research, Inc. Weekly Market Outlook Contributors: David W. Munves, CFA 1.212.553.2844 david.munves@moodys.com John Lonski 1.212.553.7144 john.lonski@moodys.com Ben Garber 1.212.553.4732 benjamin.garber@moodys.com Njundu Sanneh 1.212.553.4036 njundu.sanneh@moodys.com Yukyung Choi 1.212.553.0906 yukyung.choi@moodys.com Irina Baron 1.212.553.4307 irina.baron@moodys.com Franklin Kim 1.212.553.4419 franklin.kim@moodys.com Xian (Peter) Li 1.212.553.1404 Xian.li@moodys.com Moody's Analytics/Europe: Tomas Holinka +420 ( 221) 666-384 Tomas.holinka@moodys.com Moody's Analytics/Asia-Pacific: Jack Chambers +61 (2) 9270-8118 Jackchambers@moodys.com Emily Dabbs +61 (2) 9270-8159 Emily.dabbs@moodys.com Editor Dana Gordon 1.212.553.0398 dana.gordon@moodys.com CAPITAL MARKETS RESEARCH 2 FEBRUARY 23, 2017 CAPITAL MARKETS RESEARCH, INC. / MARKET OUTLOOK / MOODYS.COM Credit Markets Review and Outlook Credit Markets Review and Outlook By John Lonski, Chief Economist, Moody’s Capital Markets Research, Inc. Low VIX and Thin Spreads Could Be on Thin Ice The February 1 FOMC meeting minutes noted two interrelated developments. First, the narrowing by “corporate bond spreads for both investment- and speculative-grade firms” to widths that “were near the bottom of their ranges of the past several years.” Secondly, some FOMC members were struck by how “the low level of implied volatility in equity markets appeared inconsistent with the considerable uncertainty attending the outlook for such policy initiatives.” Thus, some high-ranking Fed officials sense that market participants are excessively confident in the timely implementation of policy changes that boost after-tax profits. And they may be right, according to Treasury Secretary Steven Mnuchin’s recent comment that corporate tax reform legislation may not be passed until August 2017 at the earliest. The ongoing delay at remedying the Affordable Care Act warns of a possibly even longer wait for corporate tax reform and other fiscal stimulus measures. Treasury bond yields declined in quick response to the increased likelihood of a longer wait for fiscal stimulus. Lower benchmark yields will lessen the equity market’s negative response to any downwardly revised outlook for after-tax profits. Provided that profits avoid a replay of their year-to -year contraction of the five quarters ended Q2-2016 and that interest rates do not jump, a deeper than -5% drop by the market value of US common stock should be avoided. The importance of interest rates to a richly priced and supremely confident equity market cannot be overstated. In fact, the rationale for an unduly low VIX index found in the FOMC’s latest minutes contained a glaring error of omission. Inexplicably, no men