If the Kevin Warsh Fed was already inclined to suggest the market’s “doing some of the work for them” when it comes to tightening financial conditions, policymakers will view this week’s price action as confirmatory.
Between various manifestations of what we’re generically calling “AI jitters” and, more to the FCI point, escalatory widening in some corners of the credit market, doves on the FOMC probably feel vindicated.
The credit story’s getting some real attention now. I talked at some length about it in the new Weekly, which I shamelessly (in the context of enticing readers with scary-sounding headlines) called “Something Wicked This Way Comes.”
The figure above’s just one more way to visualize the unfolding drama. It shows junk widening relative to high-grade.
This matters for the Fed if sustained. Note the emphasis. As BMO’s Ian Lyngen pointed out on Friday, the previous session’s risk-off trade triggered the biggest single-day tightening on Bloomberg’s FCI gauge since the July FOMC meeting.
“The latest episode has been fueled by wider high-yield credit spreads and weakness in equity markets, reinforc[ing] market expectations for steady policy rates next week while tempering the prospects for a rate hike at the December meeting,” Lyngen wrote, noting that one point Thursday, market-implied rate-hike odds for this year’s final FOMC meeting slipped to just 65%.
The rally at the front-end on October 22 — 16bps — compressed 2s-EFFR inside of 80bps, the tightest since the immediate aftermath of the September rate hike. The implication: The Fed won’t need to deliver as much tightening over the medium-term as previously anticipated.
Of course, all of this could be over before it really starts, which is to say it’s far from obvious that these last two weeks were anything more than a fleeting “freak out.” I mean, let’s be real here: CoreWeave ain’t goin’ under next week.
And even if it’s true that, as JonesTrading’s Mike O’Rourke put it, mega-cap US tech’s “in the midst of destroying some of the most successful, scalable, investor-friendly business models the equity market has ever seen,” we’re nowhere near any sort of existential moment for the hyper-scalers.
As for financial conditions, BMO’s Lyngen went on to note that we’re still “comfortably in accommodative territory.” And notwithstanding CCCs trading like… well, like what they are, overall high yield spreads “remain well below levels that would typically be associated with true market distress.”
At the same time, inflation’s entrenched (oh how quickly we forget when flashier headlines beckon) and a potential return to major combat operations in the Gulf doesn’t exactly suggest price pressures will fully moderate any time soon.
Warsh, then, isn’t off the hook for rate hikes. Not by a long shot. For that, he’ll need an actual credit event. Fingers crossed!
I see what you mean. The problem is our bifurcated economy. By bifurcated, I do not mean the top 10% vs. everyone else (not directly anyway), I mean the AI economy vs. everything else. With GDP currently steady at roughly 2%, unemployment historically low, and inflation at about 3.7% or so, Warsh’s clearest path forward is to hold rates (mostly) steady until something really changes. Whereas, if he truly wanted to crush inflation down to 2%, he would have to raise rates high enough to actually attenuate AI spending (however high that might be), which would then crush GDP (being as GDP is almost entirely due to AI now), resulting in an unwanted surge in unemployment, and likely a recession. Or, he could allow the bond market to reduce AI spending on its own, and then respond to changing machinations accordingly — raising (or eventually lowering) rates in response to a crisis (if needed) — as opposed to making a potentially questionable policy decision.