Global monetary conditions are tightening. But it’s not your parents’ tightening cycle. This one is drawn-out and imbalanced. Yet it is happening and it changes the relationship between return and risk. Higher quality assets have higher yields. That puts pressure on riskier assets. The most risky are those issued by highly indebted borrowers. It is not surprising that risk premiums are rising. Not all credit risk is the same when rates rise. It may get worse because the Federal Reserve will increase rates further and the European Central Bank will marginally become less accommodative. Prepare for more credit risk volatility in the months ahead.
- A core fundamental is the tightening of global monetary conditions as the slow process of exiting quantitative easing (QE) and zero/negative interest rates continues. The actual and prospective tightening of monetary conditions is creating renewed differentiation amongst risky assets as higher risk-free rates impact on relative valuations and potentially worse fundamentals call for higher credit risk premiums.
- Investors became willing to accept a higher level of credit risk when risk-free rates were zero – thus the preference for short-duration credit strategies. As risk-free rates have risen, investors have become less willing to treat all credit risk the same. There has started to be more differentiation based on relative risk-adjusted valuations. Higher risk-free rates increase the risk adjusted returns for high quality assets so riskier assets have to offer higher returns as well.
- Tighter monetary conditions are creating a re-pricing of premiums on risk assets; 2) This is a general trend but the biggest effects are where there is a perceived increase in risk as a result of either economic and political fundamentals changing; 3) Countries most at risk are those with the lowest growth rates, the highest current account balances and external debt levels, the worst fiscal balances and where domestic monetary conditions are not totally aligned with domestic economic conditions.