The big question mark is the Fed’s future moves, with analysts examining, in addition to inflation, some other data that may force the bank to curb interest rate hikes.
Markets have discounted that The Fed will raise its key interest rate by 0.75% todayas US inflation remains at historically high levels.
At the same time, however, the big question mark is the future movements of the bank with strategists looking beyond inflation to some other data that may force the Fed to reduce its aggressive pace of interest rate hikes.
According to Blooomberg’s analysis, these data concern the course of spreads, the increasing risk of bankruptcies, the shrinking of liquidity in the bond market and the growing turmoil in the foreign exchange market, with the continued strengthening of the dollar.
The course of spreads
The difference between her average yield of US investment grade corporate bonds and equivalent US Treasuries, known as the credit spread, has risen by about 70% in the past year, raising the cost of borrowing for businesses. Much of the increase came as annual US inflation data beat forecasts.
Although spreads have eased from their July high of 160 basis points, the increase underscores increasing pressure on credit markets from monetary tightening.
“Investment grade credit spreads are by far the most important metric to watch given the large proportion of investment grade bonds.”stated Chang Wei Liang, strategic analyst at DBS Group Holdings and adds that “any excessive widening of investment-grade credit spreads above 250 basis points, near the peak reached amid the pandemic, could prompt more nuanced policy guidance from the Fed».
The higher borrowing costs and the fall in share prices since mid-August have tightened financial conditions in the US to levels not seen since March 2020, according to a Goldman Sachs benchmark consisting of credit spreads, stock prices, interest rates and exchange rates. THE Fed closely monitors financial conditions to assess the effectiveness of its policy, as the president, Jerome Powell, has emphasized.
Fears of increasing bankruptcies
Another metric that can scare the Fed is the increase in the cost of protecting against the risk of corporate debt (credit default). The spread of the Markit CDX North America Investment Grade Index, which benchmarks credit default swaps on a basket of investment-grade bonds, hit a one-year high on Tuesday. The spread has doubled since early January to around 98 basis points, approaching the 2022 high of 102 basis points set in June. The rising default risk is closely correlated with the rising dollar, which is benefiting from the Fed’s rapid pace of interest rate hikes.
Reduced liquidity in the bond market
Another threat that could prompt the Fed to slow the pace of tightening is the shrinking liquidity of government bonds. A Bloomberg index for the liquidity of US government bonds is near its worst level since trading effectively “froze” due to the start of the pandemic in early 2020.
The market range for US 10-year Treasuriesas measured by JPMorgan Chase it has also fallen to levels last seen in March 2020. Thin liquidity in the bond market will add pressure to the Fed’s efforts to reduce its balance sheet, which has swelled to $9 trillion due to the pandemic. The central bank is currently selling $95 billion a month in government and mortgage bonds, draining liquidity from the system.
Strengthening of the dollar
A fourth factor that might make the Fed think twice is the increasing turmoil in the currency markets;. The dollar has strengthened significantly this year, hitting multi-year highs against nearly all of its major peers and driving the euro below absolute parity for the first time in nearly two decades.
The U.S. central bank usually ignores the dollar’s strength, but the euro’s sharp decline could fuel concern about deteriorating global financial stability. “The Fed does not want the euro to follow an even more aggressive downward path“, appreciated John Vail, strategic analyst at Nikko Asset Management.