Clear And Present Danger

Who’s afraid of credit spreads?

The Fed, historically.

Speculation is rife that overzealous policymakers, terrified of an inflation problem they’re powerless to correct but duty bound to address, will tighten the world’s biggest economy into recession, triggering a sharp de-rating in equities in the process. If you go by market pricing, the pivot to easing will occur in mid- to late-2023.

The idea, generally speaking, is that the vaunted “Fed put” is struck lower than it’s been at any time post-Lehman, and not just vis-à-vis stocks. Given labor market tightness and polls which suggest Americans overwhelmingly see inflation as the biggest problem, it’s also likely the Fed’s pain threshold in terms of lost growth momentum is higher too.

STIRs are looking for an “early” end to what’s expected to be a very truncated (albeit very aggressive) tightening cycle, and various curves would have you believe the Fed is embarking on an outright suicide mission. Notwithstanding the usual delay between inversion and downturn, you could pretty easily point to the curve (pick one) and proclaim the endeavor “over before it starts.”

Of course, that’s not supposed to be taken entirely literally. But what if we eschewed all the nuance, pontificating and equity references in favor of a simplistic view based on the rapidity of spread widening? The figure (below) provides a disconcerting answer. Based on the last two instances of Fed pivots, this cycle really was close to being “over before it started.”

“Notably, there were two instances during the last hiking cycle in which sharp upward movements in credit spreads contributed to changes in the Fed’s policy stance,” Morgan Stanley’s Julian Richers, Vishwas Patkar and Ellen Zentner wrote, in a Tuesday note, before taking a brief trip down memory lane.

“After credit spreads spiked higher in the aftermath of the first Fed rate hike at the end of 2015, Fed officials delayed further hikes for some time,” they remarked. “A more than 50bps runup in credit spreads at the end of 2018 supported the Fed’s decision to halt policy tightening.”

Those two episodes were different in many ways. Q4 2018 was indeed a period of relatively acute stress in credit markets facilitated by Fed tightening. In Q1 2016, markets were plagued by a hodgepodge of concerns, including the lingering fallout from China’s overnight yuan devaluation six months previous, collapsing oil prices and a global manufacturing slump. It was a deflationary spiral that gave rise to the so-called “Shanghai Accord.”

But this time around, the Fed is likely to look the other way for as long as it’s feasible. For one thing, overall financing costs are still accommodative and, as Morgan’s strategists and economists went on to write, “market access and issuance volumes matter as much as — if not more than — prices to the Fed.” On that front, things are going fine (figure below).

“Concessions remain elevated compared to historical norms, but continue to compress,” BMO’s Daniel Krieter and Daniel Belton remarked on Tuesday, noting that the broader IG index has now “completely retraced the widening experienced since Russia invaded Ukraine.”

Given the still open door to high-quality issuers and the spread retracement in the broad IG gauge, the Fed certainly has plausible deniability to look the other way should credit widen more, although I’d reiterate that outflows have picked up materially.

But if you’re the Fed, the main reason for ignoring early signs of stress in credit is the same as it is for “letting” stocks fall and for countenancing (even encouraging) some loss of economic momentum.

“High inflation has raised the bar on deviating from the Fed’s indicated policy path,” Morgan went on to say, in the same Tuesday note cited above. “While the last tightening cycle was largely done to combat anticipated inflation due to expected economic overheating, inflation is now a clear and present feature of the economic landscape.”

They could’ve said “clear and present danger,” but I suppose that was too hyperbolic.