Market Red Flags That Could Prompt the Fed to Increase Rate Hikes

Market Red Flags That Could Prompt the Fed to Increase Rate Hikes

(Bloomberg) — Strategists are looking beyond the headline inflation issue for another metric that could cause the Federal Reserve to slow its aggressive cycle of interest rate hikes.

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August’s ugly reading for US consumer prices last week cemented bets on a third straight 75 basis point move when the central bank hands down its next decision on Wednesday. Slowing inflation aside, other potential indicators that could cause policymakers to dial back their hawkishness include wider credit spreads, rising default risk, declining bond market liquidity, and increasing currency turbulence.

Here are some charts looking at these in more depth:

The difference between the average yield on investment-grade US corporate bonds and their risk-free Treasuries counterparts, known as the credit spread, has risen by about 70% over the past year, pushing up borrowing costs for businesses. Much of the increase came as annual US inflation data beat forecasts, shown as green flags in the chart above.

Although the spread has narrowed since July’s high, when it touched 160 basis points, the increase reflects the severe stress on credit markets caused by monetary tightening.

“Investment grade credit areas are 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 expansion of investment-grade credit that expands to over 250 basis points, near the peak of the pandemic, could prompt more nuanced policy guidance from the Fed.”

Higher borrowing costs and a decline in equity prices since mid-August have tightened US financial conditions to levels not seen since March 2020, according to a Goldman Sachs benchmark comprising credit spreads, stock prices, interest rates and foreign exchange rates. The Fed looks closely at financial conditions to gauge the effectiveness of its policies, chairman Jerome Powell said earlier this year.

Another metric that could destroy the Fed is an increase in the cost of protection against default risk on corporate debt. The spread on the Markit CDX North American Investment Grade Index, a benchmark of credit default swaps on a basket of investment-grade bonds, has doubled this year to about 98 basis points, inching closer to the 2022 high of 102 basis points set down in June. .

The increased risk of default is closely correlated with the surging dollar, which is benefiting from the rapid pace of Fed interest rate hikes.

Another threat that could encourage the Fed to slow the pace of tightening is shrinking Treasury liquidity. Bloomberg’s liquidity index for US sovereigns is close to its worst level since the pandemic brought trade to a standstill in early 2020.

Market depth for US 10-year notes as measured by JPMorgan Chase & Co. also declined. to levels last seen in March 2020, when traders struggled to find prices for even the most liquid government debt securities.

Thin bond market liquidity would strain the Fed’s efforts to reduce its balance sheet, which has swelled to $9 trillion through the pandemic. The central bank is currently renting $95 billion in government and mortgage bonds from its balance sheet each month, draining liquidity from the system.

The fourth area that may cause the Fed to think twice is the growing turmoil in the currency markets. The dollar has powered ahead this year, setting multi-year highs against nearly all major peers and driving the euro below parity for the first time in nearly two decades.

The US central bank tends to ignore the strength of the dollar, but excessive declines in the euro could fuel concerns about deteriorating global financial stability. The common currency extended losses earlier this month but its relative strength index or RSI did not. This suggests that the downside may be slowing but that bulls would need to push it back above the long-term falling trend to cast doubt on the bearish regime.

“If the euro were to fall out of bed, the Fed might not want to make that worse,” said John Vail, chief global strategist for Nikko Asset Management Co. in Tokyo. “It would be a global concept of financial stability rather than anything related to the dual mandate.”

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