While the Middle East situation stirs the commodity markets, a more concerning divergence is quietly unfolding in the credit markets. Goldman Sachs' credit strategy team has issued a warning that beneath the surface calm, undercurrents are swirling, and this "steady state" is inherently unstable.
Compared to the volatility in equity and commodity markets, credit markets have shown remarkable resilience over the past three weeks - stocks have retreated only about 5% from their historical highs, and the widening of credit spreads has been relatively limited.
However, Goldman Sachs strategist Reid Zhou and his credit strategy team believe the market is transitioning from a "shock" pricing phase to an "economic impact" pricing phase. The current calm is more akin to a stalemate in a game rather than genuine stability.
Notably, the primary pressure in the credit market is not originating from the energy sector but is concentrated in the financial sector, particularly institutions related to private credit. Bonds linked to Blue Owl, FS KKR, and private credit funds have performed the worst, with spreads on financial bonds widening by 39 basis points year-to-date.
This signal has alerted market participants: behind the noise of oil price fluctuations, the "cockroach effect" of private credit may be the deeper, underlying concern.
Credit Divergence: Financial Sector Pressure Far Exceeds Energy According to Bloomberg, the expansion of US credit spreads began even before the recent Middle East conflict erupted. A notable feature of this round of credit selling is its high consistency across industries and ratings.
The sole exception is not energy, but finance. Credit spreads for financial services company bonds have widened by 39 basis points year-to-date, with issuers related to Blue Owl, FS KKR, and private credit funds showing the weakest performance.
Credit performance in the energy sector has actually been relatively strong this year, but its outperformance was mainly concentrated in February - before the conflict began. This contrasts sharply with the stock market, where the energy sector has clearly outperformed others since the conflict started.
Specific data shows that within BBB-rated US dollar bonds, the spread difference between the energy and financial sectors was only 2.4 basis points at the start of the year. This gap widened to 13.5 basis points just before the conflict began on February 26th and has since expanded further to 18.5 basis points. The ongoing pressure on private credit is becoming the most dangerous variable for the entire credit market.
"TACO Game": Market and Policy in a Standoff The Goldman Sachs team characterizes the current market stalemate as a "chicken or egg" problem.
The market has anchored its expectations on "TACO" (Trump Always Chickens Out, implying an eventual compromise by Trump), hence refraining from large-scale selling. On the other hand, policymakers are also holding steady because significant market turbulence has not yet materialized.
Goldman Sachs states: "We are in an extremely delicate steady state against a highly unstable background. This is a game where the first to move loses."
The strategy team believes this steady state may last longer than expected, but it is ultimately transitional. Market volatility for interest rates has rapidly climbed from the 10th percentile historically to near the 70th percentile, reflecting the quick digestion of the shock phase. However, spread widening remains relatively restrained, and fund flows are essentially balanced.
Triple Vulnerabilities of the Steady State: Fund Flows, Positioning, and Irreversible Damage
Goldman Sachs analyzes the inherent fragility of the current steady state from three dimensions.
First, fundamental support still exists, but positioning pressure is accumulating. Current credit fundamentals remain supportive, with new bond issuance generally being well absorbed by the market, and total return buyers still present. Meanwhile, CTA strategies have de-risked, and some hedge positions have been unwound, alleviating valuation and crowding pressures. However, this also means that if another round of risk emerges, investors' protective buffers will be thinner.
Second, the risk of outflows from high-yield bonds is increasing. Recent signs of outflows from high-yield bonds have appeared. If outflows persist, credit beta could accelerate its downward trend. Goldman Sachs specifically notes that, with previous hedge positions already unwound, investor vulnerability to a new round of spread widening is rising.
Third, some damage is already irreversible. Even if policy concessions occur in the future, the credit market will not simply return to its pre-conflict state. Goldman Sachs believes any phased rebound is likely to be gradually digested over the medium term, although this process will likely unfold in a controlled manner rather than as a rapid reversal.
Goldman Sachs' Trading Strategy: Shorting Basis, Selling Volatility
Based on the above assessment, Goldman Sachs' credit strategy team provides specific positioning recommendations.
Firstly, shorting the basis (going long futures, shorting cash) is viewed as a preferred strategy that accommodates multiple scenarios: if a short-squeeze rebound occurs, the futures side should outperform cash due to leverage squeezes (basis narrows); if spreads enter a second wave of widening, forced selling would pressure cash, causing it to underperform futures (basis also narrows).
Regarding specific instruments, Goldman Sachs prefers high-yield bonds over investment-grade bonds. One suggested reference combination is: shorting the swap on the high-yield BB basket GS2BATAS, while going long CDX HY45. Compared to establishing a short position by shorting HYG via securities lending, using basket instruments to build a short position is more cost-effective.
For volatility strategies, Goldman Sachs continues to favor selling credit volatility, achievable through at-the-money straddles or STS strategies. Given that volatility has recently surged from below the 10th percentile to near the 70th percentile, the team prefers replacing straddles with a single option direction combined with a long gamma position on the cash side. This aims to capture non-linear returns while controlling costs.
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