European credit risk’s rally this year has been wiped out as traders race to protect themselves from a selloff that’s enveloped everything from cryto currencies to stocks.

Indices that track credit default swaps for investment grade and junk borrowers in Europe soared as much as 14 and 60 basis points (bps) respectively in August to the highest since late 2023. A similar gauge in Asia rose to the highest since May, and yield premiums for high-grade dollar bonds in the region are set for the biggest surge in 22 months, according to traders and a Bloomberg index.

The moves follow other asset classes in the throes of a wild correction, with traders pricing in a 60% chance of an emergency rate cut by the Federal Reserve within a week and a global stock rout still raging. The concern is that the Fed has been behind the curve on rate cuts and that the world’s richest economy could be heading for a recession as a result. The timing of all this, however, is crucial because of the thin volumes that are typical throughout August.

In addition to coming to terms with the realities of an economic slowdown, “investors will also need to integrate uncertainty coming from the Middle East, with the risk of a broader war looming in the background,” said Raphael Thuin, head of capital market strategies at French asset manager Tikehau Capital. “This is a lot to digest for a month of August, at a time of tight spreads coming after an extended period of strong performance.”

Credit risk and spreads had been falling for much of the year as investors chased elevated yields, and recession fears were put on the backburner, even though delinquencies have risen; the default rate for Bloomberg’s junk index climbed to 2.96%, crossing Covid era’s 1.8%. The latest gyrations suggest a turning point if concerns about a worse-than-expected slowdown in the US and its spillover effects deepen.

“The market was overdue [for] a correction and there was too little differentiation between cyclical and non-cyclical credits,” said Thomas Leys, an investment director at Abrdn. “But clearly no one expected such a sharp reaction.” 

Goldman Sachs Group Inc economists on Sunday increased the probability of a US recession in the next year to 25% from 15%, while also adding there are reasons not to fear a slump, even after unemployment jumped. The economists expect the US central bank will reduce rates by 25bps in September, November and December.

“The current risk-off in credit will peter out,” predicts Bloomberg Intelligence chief European credit strategist Mahesh Bhimalingam. “Credit metrics and quality are still quite solid and the central bank puts will soon be in action.”

  - Bloomberg