The Big Idea
Inflation, real rates and risk assets
Steven Abrahams | January 21, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The early January release of minutes from the December FOMC showed the Fed was ready to fight not just inflation but the overhang of liquidity that had swamped real rates. The minutes signaled a quick start to portfolio runoff that could begin to soak up $4.4 trillion in cash in the system from the current round of QE. Real rates have since jumped, inflation expectations declined and spreads on risk assets widened. But it is inflation expectations more than real rates driving risk spreads. Risk spreads almost certainly will go wider as the Fed drives expectations down further, but the damage should be limited.
Real rates up, inflation expectations down
The possibility of early portfolio runoff was the big surprise in the December minutes. The Fed had made the tapering schedule clear and had signaled hikes quickly after tapering finished. Portfolio runoff was new. After the last tapering that finished in October 2014, the Fed waited until October 2017 to start letting the portfolio slowly renormalize. The December minutes suggest the Fed is on a much shorter timeline. That is a big deal for real rates.
The liquidity created by global central banks, rules requiring a more liquid global banking system and persistent global savings had pushed US 10-year real rates last October to a record low of -120 bp. Real rates, of course, are just the level where the supply of money and the demand to borrow clear the market. The prospect of persistent liquidity from a massive Fed portfolio had swamped expected demand. The news of an early retreat has created some relief. US 10-year real rates since release of the minutes on January 5 have jumped 36 bp, implied inflation has dropped 23 bp and nominal 10-year rates have moved up a net 13 bp (Exhibit 1).
Exhibit 1: The FOMC minutes have triggered higher real rates, lower BE inflation
Risk assets wider
Spreads on risk assets have widened, too. Spreads on cash investment grade corporate debt, for example, have widened 7 bp while nominal spreads on par 30-year agency MBS have widened 16 bp (Exhibit 2). Some of the widening in MBS is almost certainly due to the prospect of supply coming out of the Fed portfolio sooner, and some of the widening in credit may be in sympathy with MBS. But the shifts in real rates and inflation expectations raise the question of whether one or both might be driving risk spreads and, if so, how much they might drive spreads further.
Exhibit 2: Spreads on credit and MBS have widened
The links between real rates, inflation expectations and risk spreads
Rising real rates should be bad for credit. Higher real rates mean a higher cost of borrowing. Debt costs go up, margins and profits go down. But if real rates go up because the market expects higher growth and more demand to borrow, then a rising cost of debt could get offset by rising revenues. It seems at this point that a declining expected supply of cash—not rising demand—is bringing real rates up.
On inflation, markets tend to see it in moderation as a good thing for corporate credit, and corporate profits have danced to that tune in the latest round of rising prices. Inflation pushes up nominal revenue faster than nominal costs. Take a company that makes something for $0.50 and sells it for $1.00. Inflation at 5% raises cost to $0.525 and revenue to $1.05 for a net gain of $0.025. Companies have been showing record margins and booking record profits.
Inflation also allows companies to pay off nominal debt with rising nominal margins and profits. Unless a company has floating-rate debt where costs might rise with inflation, debt costs remain fixed and become easier to cover. The more leveraged the company, the bigger the lift from inflation.
The correlation between real rates, inflation expectations and spreads
Correlations between daily changes in real rates, implied inflation and spreads in different sectors broadly show that both rising real rates and rising inflation tend to tighten credit spreads, and the impact is bigger with more leveraged credits. The correlation between daily changes in aggregate high yield corporate spreads and changes in real rates over the last five years is -0.19 while the correlation to changes in inflation expectations is -0.46 (Exhibit 3). Inflation is a more powerful predictor of tighter spreads. For aggregate investment grade corporate spreads, the correlation to changes in real rates is 0.00 while the correlation to changes in inflation expectations is -0.30. Inflation again is a more powerful predictor of tighter spreads. The tendency for inflation expectations to correlate more closely than real rates to risk spreads holds across almost all subsectors of corporate credit. For MBS, rates correlate to spreads at a very low level likely because Fannie Mae, Freddie Mac and Ginnie Mae guarantee the cash flows. For equities, measured by price changes in the S&P 500, higher expected inflation correlates with higher expected price.
Exhibit 3: The correlation of daily changes in sector spreads, real rates and BEs
The risk to spreads
The biggest threat to risk spreads seems likely to come from declining inflation expectations. The market currently prices in a steady decline in inflation over the next 10 years. Expectations for 2-year inflation stand at 322 bp, 5-year inflation at 2.75 bp and 10-year inflation at 237 bp. That leaves 5-year forward 5-year inflation is at 208 bp. That decline is already priced in, and the odds of a further steep decline in long-term inflation expectations seem low. That should limit the prospects for sharply wider credit spreads.
The latest rise in real rates may be having a bigger impact on risk spreads than the last five years suggest. This rise in real rates seems driven more by falling expected supply of cash than by rising expected growth and demand to borrow. Without growth to offset more expensive debt, credit should get hurt. The jury is still out on this one.
MBS faces its own unique risks with a quicker normalization of the Fed balance sheet, and that should splash over at least a bit into credit. But that’s a story for another day.
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The view in rates
The FOMC on January 26 could include some fireworks. The Fed seems on schedule to finish taper in March and liftoff, but it may want to set market expectations for the pace and magnitude of hikes. The Fed may want to let the market know that this round of tightening may be different from the slow pace of 2015 through 2018, and that could involve a hike of 50 bp at some points. That would be a surprise.
The Fed’s RRP facility is closing Friday with balances near $1.71 trillion. Treasury repo rates have shown some softness in the last few weeks, with SOFR dipping below 5 bp at some points. With the RRP facility paying 5 bp, it is getting heavy action. RRP balances could also rise if bank deposit rates lag the rise in fed funds and other wholesale rates. Deposits could flow to money market funds and into RRP.
Settings on 3-month LIBOR have closed Friday at 25.514 bp. It has moved up steady from 12 bp in early October as Fed hikes keep getting moved up in the market’s calendar. With markets that used to price to LIBOR now pricing to SOFR, it is worth noting that overnight SOFR has not moved in months off it’s 5 bp mark, so the LIBOR-to-ON SOFR spread keeps widening. Term 3-month SOFR has moved, however, from 5 bp in early October to close Friday at 16 bp. Term SOFR is tracking LIBOR.
The 10-year note has finished the most recent session at 1.76%, nearly unchanged on the week. The December FOMC minutes added to the hawkish tone, showing almost no remaining doves and raising the possibility of running down the Fed portfolio faster than the last time around. The 10-year real rate finished the week at negative 61 bp, up 15 bp on the week.
The Treasury yield curve has finished its most recent session with 2s10s at 75 bp, flatter by 15 bp on the week, and 5s30s at 51 bp, flatter by 10 bp on the week. The curve should continue to flatten.
The view in spreads
The strands of pandemic, inflation, growth, labor and Fed policy create an unusually wide range of possible outcomes this year and beyond. Volatility measured by the MOVE index remains elevated, reflecting the uncertainty Further volatility should add pressure for spreads to go wider, although tremendous market liquidity continues to push in the opposite direction.
Of the major spread markets, corporate and structured credit is likely to outperform, as it has since March 2020. Corporates benefit from strong corporate fundamentals and from buyers not tied to Fed policy. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand.
MBS faces new pressure for a possible quick start to Fed runoff. My colleague Brian Landy also projects that new supply of MBS will run at $60 billion a month. Without the Fed or banks to take up that extra supply, the burden would likely fall on mutual funds. Mutual funds do not have the capital to fully take up the slack.
MBS also faces pressure from new, higher loan limits on Fannie Mae and Freddie Mac MBS. Higher balances bring more negative convexity. Fed taper also reduces the amount of negatively convex loans filtered out of the TBA floating supply. The quality of TBA should erode this year, and spreads widen with it.
The view in credit
Credit fundamentals continue to look strong. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. The consumer balance sheet now shows some of the lowest debt service on record as a percentage of disposal income. That reflects both low rates and government support during pandemic. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households. Consumers are also liquid, with near record amounts of cash in the bank. Strong credit fundamentals may explain some of the relatively stable spreads.