FED flips, flops, flips?

Though seemingly days away from what would be the first increase in US interest rates in a decade, data points which indicate a significant turn in the credit cycle could already be underway keep turning up.

First, the rise in the dollar has stressed emerging market borrowers. During 2015, EM credit spreads against similar maturity US Treasury bonds have widened considerably, Exhibit 1.

Exhibit 1: Emerging market bond yield spread to US Treasuries

Second, yields in the US high yield market have moved sharply higher in recent months, Exhibit 2, and are close to their highs since 2010. As sovereign yields have remained relatively stable, the credit spread has also widened to levels not seen since the European sovereign debt crisis of 2012.

Exhibit 2: US Junk bonds underperform as spreads widen

Third, in the space of a weekend two credit funds (Stone Lion and Third Avenue) have suspended redemptions, apparently due to a lack of liquidity in the US high yield bond market. While not nearly as shocking as the markdowns on supposedly safe money market funds in the lead-up to the 2008 crisis, this indicates to us that the flow of cash from reach-for-yield investors is drying up. The widening of yields is also not only contained to the known issues in the energy sector.

Fourth, prices of US senior leveraged loans have continued to decline over the autumn even as these would normally benefit from expectations of higher interest rates; this positive dynamic has been more than offset by concerns over credit quality, Exhibit 3.

Exhibit 3: Performance of US leveraged loan index now negative y-o-y

However, it is not at all in our view surprising that risk premia in US credit markets have widened from the very compressed levels which had already attracted policymakers’ opprobrium in recent years. What is remarkable is that investors are turning their back on issuers well before a single rate increase from the Fed. In 2007 the first signs of cracks in the financial system occurred 2 years after the Fed had been finished tightening policy, Exhibit 4.

During the previous rate cycle, financial distress occurred after the peak in rates…

We are now wondering if last week’s declines in both equity and credit markets may have unnerved Fed policymakers. The WSJ is today reporting the Fed officials are worried that US rates will go up in December, but only to come back down soon after, as has happened with every other central bank which has raised rates since the 2007-2009 period.

The concern appears to arise from the acknowledgement that long-run growth rates, and in turn equilibrium interest rates, are unlikely to be nearly as high as before. This is due to weaker productivity trends, adverse demographics and levels of debt/GDP, all of which we have discussed at length previously. In consequence, rates cannot be cut as aggressively if demand weakens in future.

It is not immediately clear if today’s article, sourcing Fed officials just before this week’s FOMC meeting is intended to calm markets with some ‘leaked’ forward guidance that rates are not on a one-way upward path, or even perhaps is paving the way for yet another U-turn on a December rate increase. But the summary is rather ominous for US growth if reflective of Fed officials’ private views as it highlights “the age of unconventional monetary policy begun by the 2007-2009 financial crisis might not be ending”.