The 2003-07 credit cycle provides an instructive template on how the current cycle may eventually play out.

C orporate credit spreads narrowed throughout 2006 even after the Fed had boosted its target lending rate above equilibrium. Spreads continued to trend lower in early 2007 even after our Corporate Health Monitor moved into “Deteriorating Health” territory. While these two factors together created a formidable headwind for credit, spreads still needed a catalyst before reversing direction.

That catalyst appeared in mid-2007 as the Senior Loan Officer survey revealed that banks were actively tightening lending standards. The supply of credit to low-quality firms was shut off and the market quickly handed high-yield investors a painful setback. High-yield bonds underperformed the Treasury market by nearly 2000 basis points between June 2007 and March 2008 as the index spread widened to 830 basis points.

Such a turning point is unlikely to materialize soon. Monetary policy is exceptionally easy and our measure of non-financial corporate sector health remains in improving health territory, although admittedly is showing some signs of decay. A further deterioration in corporate health will be an important signal for caution. That said, it will not be enough on its own to end the rally, especially given the strong starting point of corporate balance sheets. Therefore, spreads are likely to trend lower until both the Fed and the banking sector are tightening credit conditions. This point is probably several years away.

Bottom Line: The rally in high-yield has further to go, despite the dramatic narrowing in spreads to post-crisis lows.

The below article is reprinted from New Daily Insights – BCA’s first interactive service. Launching Monday, May 13, 2013, the service will include several new and important features: Insights, Inside BCA, Ask A Strategist and Polls.

Originally published May 10, 2013

Last December, our European Investment Strategy service predicted that “2013 would be the year of the big U-turn on obsessive austerity”.

Recent developments now offer evidence that this prediction is coming true.

• Recent statements from key policymakers in the euro area indicate that the public debate on austerity is shifting.
• Most euro area economies have made big dents in their structural deficits. Indeed, many have moved into a structural primary surplus, giving Brussels plenty of excuses for leniency.
• Periphery current accounts have also moved into surplus, thereby reducing the risk of financing problems.

S everal factors are going to make it easier for Europe’s policymakers to backtrack on obsessive austerity. For example, the link between austerity and poor economic performance is very clear. Also, financial markets support some austerity slippage: the election of anti-austerity forces in Italy, budget deficit slippage in Spain, and the Portuguese Constitutional court’s decision to strike down some austerity measures has had no adverse effect on the ongoing bond market rally.

Also, as highlighted in our previous research, ‘Abenomics’ offers a template for Europe. Japanese Prime Minister Abe pledged a fiscal stimulus equal to 2.3% of GDP to be launched in 2013, which did nothing to dent the rally in JGBs. Abe has illustrated the importance of accumulating political capital through monetary and fiscal stimulus measures, in order to pursue structural reform later in his term. The idea is to establish credibility by generating nominal growth, and then to push through unpopular and painful reforms.

Bottom Line: We expect that European policymakers will de-emphasise austerity so that they can re-emphasise structural reform.

Interested in the market implications of decreased austerity policies in Europe? We’ve covered them in New Daily Insights.