Tension Amid US Debt Ceiling and Unlocking Opportunities in Credit

Published on 29 May 2023

Scott Kimball, chief investment officer at Loop Capital, discusses how trading desks should plan for a week of market volatility as the US tries to avert default and identifies where opportunities can be found in credit.

North America

  • Equities bid-ask spreads were much wider and investment-grade bond spreads were tighter week on week, and for the year.
  • US axe data, which is within normal ranges, indicates a higher proportion of bids versus asks in credit.
  • Primary Equities: Multiple IPOs in Tech, Industrials, and Materials are expected on Nasdaq and NYSE. 
  • US axe data, which is within normal ranges, indicates a higher proportion of bids versus asks in credit.

Europe / UK

  • Bid-ask spreads in equities and Investment-grade bonds saw no major changes and appear to have stabilized.
  • Inflation and unemployment data on Germany and France is expected on Wednesday, while Inflation and unemployment numbers for the wider Eurozone will be out Thursday.
  • In primary equities: there are IPOs expected in Energy on Euronext Paris on Wednesday.
  • EU axe data, which is within normal ranges, suggests a slightly higher proportion of EU dealer bids Vs asks in credit
  • GBP axe data, within normal ranges, suggests much higher net selling Vs buying of credit

Transcript of Interview:

Jo Gallagher: Welcome to Trader TV This Week.

In North America liquidity has been mixed across assets, but the upcoming four day trading week could be tense as the US tries to press ahead with lifting the debt ceiling before the June deadline.

In Europe and the UK, liquidity seems to have stabilized, week on week, in equities and bonds, but this week could see volatility and downward pressure across stocks as EU economies retract when inflation remains sticky.

Now in more detail. In North America, last week’s volumes were largely unchanged from the week before and are just below average levels for the year. Bid ask spreads were much wider week on week and were wide for this year, indicating liquidity seems to have worsened. Volumes in US investment grade bonds dropped last week compared to the high seen in the week previous, but ranging just above normal levels for the year.

Bid ask spreads appear tighter week on week for 2023 levels, indicating liquidity has yet again improved. This week traders have a four day trading week, but from Tuesday onwards, markets could see some volatility as the US government faces pressure to raise the debt ceiling ahead of the so-called axe date. We’ll have data on job openings on Wednesday, but traders will be tentatively awaiting the leading indicators on the US’s unemployment rate and non-farm payrolls on Friday.

We can expect a busy week for primary equities with IPOs expected in tech industrials and materials on NASDAQ and the New York Stock Exchange. US axe data, which is within historical ranges, indicates dealers bids have increased by 5.1% over asks in the past week, suggesting an increase in net buying of products going into the week ahead.

In Europe and the UK last week, the data reading for equities was a bit trickier, but overall equity share volumes appeared to be up compared to the previous week. A lot of the flows were seemingly from spikes in OTC and dark trading as last week saw the UK inflation results come in higher than estimated. And European stocks saw a sell off following news that the EU’s largest economy, Germany, entered into a recession.

Equities bid ask spreads fluctuated last week but overall saw little change compared to the week prior and appears to be around normal ranges for the year. Volumes for euro investment grade bonds were higher week on week and overall levels were slightly above average for 2023. Liquidity appears to have stabilized as bid ask spreads remained tight, but little difference was seen week on, week.

After a long weekend markets will be awaiting leading indicators on inflation and unemployment from Germany and France on Wednesday and wider eurozone inflation and unemployment numbers will be out on Thursday. In primary equities, we can expect IPOs and energy on Euronext Paris on Wednesday.

EU axe data, which is within normal ranges, indicates the proportion of EU dealers bids vs asks has slightly increased by 0.6%. GBP dealer asks are up by 5.2% against bids over the past week, suggesting a skew towards selling vs buying going into the week ahead.

I’m Jo Gallagher and now joining me to discuss the week ahead we have Scott Kimball from Loop Capital.

Scott, welcome to the show.

Scott Kimball: Thank you. Always excited to be here with Trader TV.

Jo Gallagher: Looking at North America, we’ve a tense week ahead. What are some of the things that traders in that region need to be preparing for?

Scott Kimball: I would be prepared for that tension to persist. We talk about this to our meetings and our contact points here at Loop Capital Asset Management. The issue is things like the debt ceiling are not a single solution or a single day solution event. These things can persist. They have to go through Congress. There’s lots of negotiations, as we saw with Representative McCarthy’s own confirmation hearing as Speaker of the House. He doesn’t exactly have full support of his own party. So we expect tension to remain high. And with tension comes volatility. If we look at the US Treasury curve, we’ve seen persistent volatility, large standard deviation outcomes and big swings, not just in the Treasury curve, but how that Treasury curve is affecting other asset classes. So keep an eye on credit and credit volatility as well.

Jo Gallagher: What will traders be setting their sights on after the debt ceiling?

Scott Kimball: You know, the Federal Reserve is still in focus. We’ve had lots of iterations of this Fed tightening cycle from the market’s own perception. It started off with, ‘the Fed’s hiking now, but they’re going to cut later.’

It’s moved to, ‘the Fed’s going to hike some more, but that’s only moving us to a higher perch from which they’re going to cut.’

And then it’s gone to, ‘well, maybe they’re just going to pause.’

Inflation, while better on a headline basis, is still running an annualized rate in and around the high 4 to 5%. That is several hundred basis points above the Fed’s own inflation target. Our view here at Loop Capital is that the Fed is likely going to have to continue to inch higher on their rate policy, and that is something we don’t think the market is really coming to grips with. If you look at futures, they’re implying a slight chance of about 25 basis points. We think it’s higher than that. We think that 25 basis points will come to fruition. That’s going to create a lot of volatility, but a lot of opportunity.

Jo Gallagher: Looking across to Europe, what will traders in that region need to be preparing for?

Scott Kimball: Inflation, volatility, credit spreads volatility, equity market volatility, all of those volatility services are on the rise. Now, in Europe, it’s exacerbated by a geopolitical event that’s going on in Ukraine. Major implications there, everything from a pipeline being bombed to the main producer being at odds with the rest of Europe and threatening and at times cutting off the supply of things like gas. We think from a longer term investor perspective, credit curves in Europe, particularly those related to the banking system, falling credit squeeze in particular, those should be steeper. There should be a very pronounced positive term structure for additional credit risk in Europe. That doesn’t always happen.

At times where it’s too steep perhaps, it’s a good buying opportunity of longer dated credit. At times where it is perhaps flattening and you don’t think you’re being compensated appropriately, it’s a good time to shorten and go up in quality, get out of the lower quality, subordinated structures and into the higher quality or senior structures.

That’s going to be a persistent theme in Europe and the volatility is going to keep swinging that seesaw on where the value is. So the question is what do you do if you’re trading or investing? We believe in Europe and the US it’s follow the value.

Jo Gallagher: And how would you trade and capitalize on the European inflation environment, right now?

Scott Kimball: The ECB is pricing in a 50 basis point increase in their short term funding rates. The US market is kind of grappling with the idea the Fed may hike once more, maybe not, but is basically pricing in a pause or very near to a pause.

Our particular perspective is that inflation is not going to let any central bank off the hook yet. So don’t expect either of them to stop hiking, but nevertheless, what we’re seeing is that differential opinions is creating volatility and frictions between the marketplaces.

The opportunity, however, is at various times you can look at the European marketplace, buy European credit, particularly high yield. If you’re going to put this trade on, do it in risk. You know, high yield, 3 to 5 year maturities and you hedge them back to dollars – there’s positive carry.

Where we are now, US dollars have strengthened. It’s becoming a bit more marginally attractive to take that trade off and buy in the US dollar market. So you’re seeing it in the bid ask spreads, you’re seeing it in the trades volumes. You’re seeing a little more buying of US credit, a little more selling of Europe right now. So if you’re a trader, that’s really where we think the money is.

Jo Gallagher: Thank you, Scott, for your insight and thank you for watching. This has been Trader TV This Week.