Strategists are looking for important indicators other than inflation that could make the Federal Reserve (Fed) change its aggressive rate hike plan Sexual contraction, deepening turmoil in the foreign exchange market.
1. Widening of credit spreads
The yield on average investment-grade corporate bonds in the US, relative to the risk-free yield from the US Treasury, is the so-called credit spread. Credit spreads have jumped 70% over the past year, and corporate borrowing costs have risen rapidly, largely because recent US inflation rates have been higher than market expectations.
Although the current spread has slipped from its peak of 160 basis points in July, the cumulative increase is still large, underscoring the growing pressure on credit markets amid financial tightening.
Chang Wei Liang, chief strategist at DBS Group Holdings, said: “Investment grade credit spreads are by far the most important indicator due to the high proportion of investment grade government bonds. If the investment grade credit spread widens above 250 basis points, close to The peak during the pandemic could prompt the Fed to refine its policy guidance.”
US financial conditions have tightened in mid-August to levels not yet seen in March 2020 as borrowing costs rose and share prices fell, Goldman Sachs compiled a gauge of credit spreads, stock prices, interest rates and exchange rates. Fed Chairman Powell said earlier this year that financial conditions are the Fed’s indicator of policy effectiveness.
2. Greater default risk
Another indicator is the cost of contracts to insure against default on corporate bonds. Looking at the “Mark CDX North American Investment Grade Index Spread,” a measure of a basket of investment grade bonds, credit default swaps (CDS), has doubled since the start of this year to 98 basis points, which is pretty close to the peak of 102 basis points seen in June this year.
Default risk is closely linked to the appreciation of the dollar.
3. bond market liquidity shrinks
Liquidity in the US Treasury market is shrinking. Bloomberg metrics tracking US Treasury liquidity are at their worst since the start of the pandemic in early 2020.
The depth of the US 10-year Treasury bond market tracked by JPMorgan has also fallen to lows seen in March 2020. Even the most liquid government bonds at the time were hard to match.
Thin liquidity in the bond market will add to the pressure on the Fed to shrink its balance sheet. The Fed currently lets $95 billion in Treasury bonds and mortgage-backed securities mature each month without having to invest their principal, removing liquidity from the financial system.
4. Currency volatility deepens
Another indicator that could make the Fed think twice is an increasingly volatile currency market. The dollar has been on fire this year, hitting multi-year highs against all major currencies and even pushing the euro below parity.
The Fed typically does not watch the dollar appreciate, but excessive depreciation of the euro could fuel fears that global financial stability will deteriorate. Although the euro continued to depreciate earlier this month, the relative strength index (RSI) did not continue to decline, which may indicate that the euro’s decline has slowed, but does not mean that the trend line is on i long term floor suspended.
John Vail, chief global strategist at Nikko Asset Management, said the Fed does not want to let the euro depreciate too much.
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