(Bloomberg) — Strategists are looking beyond the core problem of inflation to other potential market metrics that could cause the Federal Reserve to slow its aggressive cycle of rate hikes.
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An ugly August reading for US consumer prices last week confirmed bets on a third straight move of 75 basis points when the central bank makes its next decision on Wednesday. Aside from a slowdown in inflation, other possible indicators that could cause policymakers to reverse their hawkishness include wider credit spreads, widening default risk, declining bond market liquidity and increasing foreign exchange turmoil.
Here are some charts that look at these in more detail:
The difference between the average yield on investment-grade US corporate bonds and their risk-free government bond counterparts, called credit spreads, has widened about 70% over the past year, driving up borrowing costs for companies. Much of the increase is due to the fact that the annual US inflation data has beaten forecasts, shown as green flags in the chart above.
While spreads have narrowed from their July high of hitting 160 basis points, the rise underscores the mounting stress on credit markets due to monetary tightening.
“Investment-grade credit spreads are by far the most important metric to monitor given the high proportion of investment-grade bonds,” said Chang Wei Liang, macro strategist at DBS Group Holdings Ltd. in Singapore. “Any excessive increase in investment-grade credit spreads to more than 250 basis points, close to the pandemic peak, could lead to more nuanced policy advice from the Fed.”
Higher borrowing costs and a decline in stock prices since mid-August have tightened US financial conditions to levels not seen since March 2020, according to a Goldman Sachs benchmark composed of credit spreads, stock prices, interest rates and exchange rates. The Fed is closely monitoring financial conditions to gauge the effectiveness of its policies, Chairman Jerome Powell said earlier this year.
Another measure that may startle the Fed is a rise in the cost of default protection against corporate debt. The spread on the Markit CDX North America Investment Grade Index, a benchmark of credit default swaps on a basket of investment grade bonds, has doubled this year to about 98 basis points, bringing it closer to the 2022 high of 102 basis points that was recorded in June was reached. .
The increasing risk of default is closely linked to the rising dollar, which is benefiting from the rapid pace of Fed rate hikes.
Another threat that could prompt the Fed to slow the pace of tightening is the dwindling liquidity of government bonds. A Bloomberg liquidity index for US Treasuries is near its worst level since trading virtually stalled due to the onset of the pandemic in early 2020.
The market depth for US 10-year bonds, as measured by JPMorgan Chase & Co., has also fallen to levels last seen in March 2020, as traders struggled to find prices for even the most liquid government bonds.
The limited liquidity in the bond market would put pressure on the Fed’s efforts to shrink its balance sheet, which rose to $9 trillion due to the pandemic. The central bank is currently rolling $95 billion in government and mortgage bonds off its balance sheet every month, draining liquidity from the system.
A fourth area that could prompt the Fed to think twice is the growing turmoil in the currency markets. The dollar has advanced this year, hitting multi-year highs against nearly all of its major counterparts and pushing the euro below par for the first time in nearly two decades.
The US central bank generally ignores the strength of the dollar, but excessive falls in the euro could fuel concerns about the deterioration of global financial stability. The common currency extended losses earlier this month, but the relative strength index or RSI did not. That suggests that the downtrend may be slowing, but bulls should push it back above its long-term bearish trendline to question the bearish regime.
“If the euro were to fall out of bed, the Fed might not want it to get any worse,” said John Vail, chief strategist for Nikko Asset Management Co. in Tokyo. “It would be more of a global concept for financial stability than anything related to the dual mandate.”
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