Market warning signs that could prompt the Fed to slow rate hikes

(Bloomberg) — Strategists are looking beyond the key issue of inflation for other potential market metrics that could cause the Federal Reserve to scale back its aggressive cycle of interest rate hikes.

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An ugly August reading for US consumer prices last week cemented bets on a third consecutive 75 basis point move when the central bank issues its next decision on Wednesday. Putting aside a slowdown in inflation, other potential indicators that may cause policymakers to scale back their hard line include wider credit spreads, higher default risk, reduced bond market liquidity and growing currency turmoil.

Here is a series of charts that break this down in more depth:

The difference between the average yield on investment-grade U.S. corporate bonds and their risk-free Treasury counterparts, known as the credit spread, has risen about 70% over the past year, driving up investment costs. debt for companies. Much of the increase is due to higher than expected US annual inflation data, shown as green flags in the chart above.

Although spreads have receded from their peak in July, when they hit 160 basis points, the increase underscores the heightened tension in credit markets due to monetary tightening.

“Investment-grade credit spreads are by far the most important metric to watch given the large proportion of investment-grade bonds,” said Chang Wei Liang, macro strategist at DBS Group Holdings Ltd. in Singapore. “Any excessive widening in investment-grade credit spreads beyond 250 basis points, near the peak of the pandemic, could prompt more nuanced policy guidance from the Fed.”

Higher borrowing costs and a drop in equity prices since mid-August have tightened US financial conditions to levels not seen since March 2020, according to a Goldman Sachs benchmark index made up of spreads from credit, stock prices, interest rates and exchange rates. The Fed is closely watching financial conditions to gauge the effectiveness of its policy, Chairman Jerome Powell said earlier this year.

Another metric that may scare the Fed is an increase in the cost of hedging against the risk of corporate debt default. The spread on the Markit CDX North America Investment Grade Index, a benchmark of credit default swaps on a basket of investment-grade bonds, has doubled this year to around 98 basis points, inching closer to its high of 2022 of 102 basic points established in June. .

The rising risk of default has been closely related to the rise of the dollar, which is benefiting from the Fed’s rapid pace of interest rate hikes.

Another threat that may lead the Fed to slow down the rate of adjustment is the reduction in the liquidity of the Treasury. A Bloomberg liquidity index for US sovereign debt is near its worst level since trading came to a virtual standstill due to the onset of the pandemic in early 2020.

The depth of the US 10-year note market, as measured by JPMorgan Chase & Co., has also shrunk to levels last seen in March 2020, when traders struggled to find prices even for bonds. more liquid public debt.

Thin bond market liquidity would add pressure to the Fed’s efforts to shrink its balance sheet, which has soared to $9 trillion during the pandemic. Currently, the central bank is allowing $95 billion in government and mortgage bonds to roll off the balance sheet every month, draining liquidity from the system.

A fourth area that may cause the Fed to think twice is the growing turmoil in currency markets. The dollar has advanced this year, setting multi-year highs against almost all of its major counterparts and pushing the euro below parity for the first time in nearly two decades.

The US central bank generally ignores dollar strength, but excessive falls in the euro may fuel concerns about worsening global financial stability. The common currency extended losses earlier this month, but its Relative Strength Index or RSI did not. That suggests that its downtrend may be slowing, but the bulls would need to push it back above its long-term downtrend line to call the bearish regime into question.

“If the euro falls out of bed, the Fed may not want that to get any worse,” said John Vail, chief global strategist at Nikko Asset Management Co. in Tokyo. “It would be more a concept of global financial stability than something related to the double mandate.”

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