Catching the bond market breakaway
FT subscribers can click here to receive Market Forces every day by email.
This summer looms as one in which central banks catch up with bond markets that have long reflected expectations of policy easing.
The second day of testimony from Jay Powell to Congress has not shifted from the tone he set on Wednesday, with the Fed chair telling the Senate Banking Committee there is room to ease policy as the neutral rate is lower than previously thought. A rate cut beckons — a 25 basis points trim rather than 50bp — as Thursday’s big data release, the US consumer price index for June, arrived a touch above expectations, with the core measure rising to 2.1 per cent for the past year.
In the inflation stakes, the Fed is clearly concerned at how its preferred measure of core inflation — the personal consumption expenditures price index — is running at an annual pace of 1.6 per cent, below policymakers’ 2 per cent target.
While Thursday’s CPI data extended the recent rise in market expectations of inflation, a current 10-year break-even rate at 1.76 per cent has not surpassed 2 per cent since November.
The bigger issue here, and the real elephant in the room, is that of recession.
Paul Shea at Miller Tabak & Co says the gist of Mr Powell’s testimony and the June meeting minutes from the Federal Open Market Committee is one of being . . .
“ . . . very worried about a business investment forecast that has gone from bad to worse in recent weeks. The FOMC will try to avoid using the word ‘recession’ but they are becoming increasingly worried about the possibility of one.”
Paul also makes the point:
“Consumption may be 70% of the US economy but it is investment, not consumption, which drives most business cycles. Problems typically first appear in residential investment before spreading to business investment, before finally appearing in consumption and the labour market. With housing already weak, it is thus impossible for the Fed not to equate a poor business investment outlook with heightened risk of a downturn.”
Such concerns are not at the forefront of the US equity market. Mr Powell’s dovish testimony has Wall Street eyeing record territory. Investor sentiment is leaning towards an “insurance” easing from the Fed that duly extends the business cycle along with bolstering business and consumer confidence.
But John Velis at BNY Mellon makes the point that “loading up on stocks is not a winning play” once the Fed starts an easing cycle. Equity bulls will quibble that an insurance cut is not necessarily the start of an extended easing cycle, so the current divergence between government bond yields and equity valuations has further room to run over the summer.
But John adds:
“The fact is that equities usually underperform at the beginning of easing cycles and it’s more likely that what causes the Fed to cut rates (weak growth, rising financial risk) drags equities down with policy rates.”
Then there is the credit market where both investment-grade and high-yield debt have performed well so far this year, although there has been a tilt towards stronger credit quality.
Margaret Kerins and Daniel Belton at BMO Capital Markets have compiled a list of eye-popping figures on the US credit market:
“The investment-grade corporate debt index is now $6.55tn, or 31 per cent of GDP versus 14 per cent in 2006. Triple B-rated debt comprises about half of the high-grade index versus a share of 35 per cent in 2006. The median net debt to Ebitda ratio of the investment-grade index is now higher than each of the last four cycle highs. Mutual funds hold 20 per cent of outstanding IG debt, up from 8 per cent in 2006.”
Among the implications BMO writes:
“Corporate leverage is significantly higher than recent peaks preceding economic downturns. In a downgrade cycle, the difference between BBB and BB tends to widen substantially, in excess of 300bp in each of the last two downturns.”
Given the rise in mutual fund holdings of investment-grade paper, there is scope for forced sales should corporate bond ratings enter high-yield territory. And as BMO notes:
“Primary dealer capacity to absorb corporate debt is limited due to regulatory changes.”
With the corporate earnings results season looming, here’s one telling observation from the bank:
“Given the increased composition of BBB in the investment-grade index, when an earnings recession hits, spreads should widen by about 15-20% more than during similar past experiences.”
For now the prospect of Fed easing and a general hunt for yield is keeping the credit show on the road. Already, a small number of eurozone high-yield bonds have entered the universe of negative-yielding paper, highlighting how the reach for fixed returns is only becoming further alienated from fundamentals as central banks prepare the ground for easing (See Quick Hits on the ECB meeting minutes.)
But as BMO concludes:
“In the near term, investment-grade spreads should remain at the narrow end of the range as the market prices to perfection in terms of Fed policy calibration. However, when the damage from the trade war begins to show up in profits, spreads will have to reflect the increased downgrade and default risks.”
Oxford Economics adds:
“A Fed put cannot reverse the economic slowdown that is currently under way. And economic slowdowns are usually good for Treasuries, not so good for high-grade credit and pretty bad for lower-grade debt.”
“The credit risk premium — proxied as the gap between the average HY and IG spreads — will widen with weaker growth as credit quality suffers with weakening profit growth.”
This is why this year’s pronounced rally in global government bonds is so troubling. It looks vulnerable to a sharp rise — as seen in late 2016 — should the global economy regain momentum, but it’s signalling not just an insurance cut but the onset of a new easing cycle. Such an outcome means equities and credit would endure the fate of the dropped cyclist, lagging the Peloton pace set by government bonds.
Quick Hits — What’s on the markets radar
ECB prepares to act — That’s the message from the central bank’s meeting minutes from June, released today and which note:
“Potential measures to be considered included the possibility of further extending and strengthening the governing council’s forward guidance, resuming net asset purchases and decreasing policy rates.”
With the Fed signalling a rate cut at the end of the month, the risk for the ECB is that unless it follows through at its upcoming meeting on July 25, the euro may well climb further.
Neil Mellor at BNY Mellon says a stronger euro is “not a benign issue for the ECB”. He adds:
“Whether the rhetoric equates to immediate policy action is one thing; whether the ECB can satisfy the market quite another.”
Buyers pull back from 30-year Treasury sale — Thursday’s $16bn bond auction attracted tepid demand, hardly a surprise as the yield curve steepens ahead of Fed easing. Non-primary dealer demand was 66.8 per cent versus a recent average of 75.2 per cent.
I’d love to hear from you. You can email me on email@example.com and follow me on Twitter at @michaellachlan.