In recent months, global credit markets have experienced a strong rally in risk assets, thanks in large part to a $1 trillion central bank liquidity injection. However, Citigroup Inc. warns that this tailwind may soon turn into a significant drag, as policymakers return to quashing inflation and extinguishing the banking-sector fire that led to the liquidity injection.
According to Matt King, Citi's global markets strategist, "With peak liquidity past, we would not be at all surprised if markets were now to experience a sudden pressure loss. Keep watching the liquidity data — and buckle up." Corporate debt markets had their best first quarter since 2019, despite concerns about the economy, as central banks continued to raise interest rates. However, the recent credit rally has erased losses caused by bank collapses, and as central banks shift back to a tighter policy stance, markets may experience a sudden pressure loss.
Citigroup warns that central bank policy shifts could subtract $600 billion-$800 billion in global liquidity in the coming weeks, undermining risk in the process. The only thing that could halt the cash exodus is another run on financial institutions, which looks highly unlikely. The return to tighter policy may already be underway, according to King, who adds that markets, with the partial exception of US real yields, haven't noticed yet."
Junk bonds are most likely to suffer from this reversal, as they had swiftly recouped losses caused by the recent banking crisis. Despite robust demand for the debt, aided by relatively easy financial conditions, rates ratcheting higher and major economies like the US teetering on the brink of recession or even stagflation, don't well for highly-indebted borrowers. Stubbornly high inflation will force central banks to keep the tightening pressure on, which would cool demand while also boosting debt-service costs, thereby hurting the weakest companies most.
Moreover, an economic slowdown also means earnings will suffer, hastening credit downgrades, defaults, and distress. This scenario is especially concerning for the weakest companies, which could face significant difficulties in managing their debt. Citigroup expects almost all companies to stall or go into outright reverse, which would subtract a considerable amount of global liquidity in the coming weeks, undermining risk in the process.
Bond buybacks from European real estate companies like CPI Property Group SA, Aroundtown SA, and Sweden's Heimstaden Bostad AB have been met with intense investor demand, as pessimism about the outlook for the sector drives away other potential buyers. Elsewhere, Europe's asset-backed debt market is having its busiest spell in months, as borrowers offer deals that were put on ice during turmoil in the banking sector.
In conclusion, while the recent rally in risk assets has been driven by a central bank liquidity injection, Citigroup warns that the tailwind may soon become a drag, as policymakers shift back to a tighter policy stance. This could subtract a significant amount of global liquidity in the coming weeks, undermining risk in the process. Junk bonds are most likely to suffer from this reversal, as highly-indebted borrowers could face higher debt-service costs and potential credit downgrades, defaults, and distress.
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