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Derivatives

Transatlantic credit convergence as vol falls

Tumbling volatility over the past months has caused US and European corporate credit risk prices to converge, despite credit investors bracing themselves for diverging monetary policies.

In a speech on Monday, Federal Reserve chair Janet Yellen remained positive about an interest rate increase in the coming months, while Wednesday marked the start of the European Central Bank's corporate bond buying programme. The positive risk sentiment in both regions has caused corporate credit risk to fall since February’s highs, and credit index volatility has fallen in tandem.

The Markit VolX Indices, which track realised volatility in the European and North American credit derivatives markets, have fallen. The Markit VolX Europe index, which tracks volatility among European corporate credits, has dropped to 35.73%, from 62.57%, for 20 and 90 trading day rolling periods, respectively.

Likewise, the Markit VolX.NA.IG index, which tracks US corporate credit volatility, has fallen from 43.06% to 33.07%. Volatility among European names remains higher, having yet to fully shake off worries over its banking sector and uncertainty around the upcoming Brexit vote. It has meant that, despite diverging monetary policies, credit risk among both regions has converged.

This is demonstrated by the basis (spread differential) between the Markit iTraxx Main Europe index and the CDX IG index, which has tightened to 1bp over the past week.

That scenario is in stark contrast to the last time monetary policies were set to diverge. Last December, the Fed started tightening, which led the basis to spike to 15bp as investors foresaw greater risks stemming from higher US rates. In the end, market volatility called for caution, while the ECB bolstered monetary stimulus in Europe.

Yet the latest levels show the Markit iTraxx Europe main index and the CDX.NA.IG index currently trading at 73bp and 74bp, respectively. If short term worries (Brexit, for example) were to dissipate in Europe, and/or risks in the US flare up again (overseas volatility, weak inflation, weak demand, low productivity) the basis between European and US corporate credit has cause to widen once again.

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