The Big Idea
Brace for impact
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. This material does not constitute research.
The notion of financial conditions seems a little abstract on most days, but not so much lately. Rates are higher, equities lower, credit spreads wider and volatility up. Markets in Treasury debt, MBS and credit have thinned, become more prone to gaps in pricing. Some issuers have backed away from the market. Credit has become more expensive and harder to get. Conditions have clearly tightened, and quickly. If history is a guide, the market has priced for a hard landing.
Measures of financial conditions have sprung up from a handful of providers in the decade since Dodd Frank set up the Financial Stability Oversight Council. Goldman Sachs, Bloomberg, the federal Office of Financial Research and the Kansas City Fed each offer one. The Chicago Fed offers two. Some report daily, some weekly, some monthly. All combine some measures of rate and credit spreads and volatility. Some include equity performance. All of these measures have reflected tighter financial conditions as the Fed has rolled into its latest hiking cycle.
Tightening conditions through a Fed hiking cycle echo not the Fed of the 2000s or 2010s but instead the Fed of the 1990s. Both the Goldman Sachs Financial Conditions Index and the Bloomberg Financial Conditions Index, adjusted so a reading of 100 reflects neutral, have long histories and report daily. In the two hiking cycles of the 1990s—from 1994 to 1995 and from 1999 to 2000—the average of these indices showed financial conditions generally tightened from start to finish (Exhibit 1). After each cycle, the Fed quickly reversed course, suggesting policy had tightened too much. But in the hiking cycle from 2004 to 2006, the average of the measures showed conditions eased. And in the cycle from 2015 to 2018, the average of the measures shows conditions ended up flat. Goldilocks would have like the Fed of the 2000s and 2010s.
Exhibit 1: Financial conditions have tightened unusually fast as Fed hikes begin
Note: Bloomberg FCI adjusted to have a base of 100 to make it comparable to the Goldman Sachs FCI.
Source: Bloomberg, Amherst Pierpont Securities
From the Fed’s first hike this year on March 16 and running through May 10, the average of the two financial conditions indices is up more than any other hiking cycle since the 1990s. Even though Fed policy is still easy by almost any measure, the market has priced in aggressively higher fed funds rates and a long course of balance sheet normalization, and it has revalued equity, widened credit and MBS spreads and kept implied and actual volatility relatively high. Measures of financial conditions reflect all of this.
The messaging between the Fed and the market can sometimes seem like a hall of mirrors, with the Fed both guiding the market and then reading the market to help calibrate policy. Little in Fed messaging suggests for now that the market has it wrong, at least for the implied forward path of policy rates reflected in fed fund futures, OIS or the Treasury curve. But the market has to look beyond foreseeable fed funds to their impact on longer rates, credit and other markets. The sharp tightening of financial conditions suggests the market is pricing for a slowdown in growth, if not recession, and a potential quick reversal of Fed policy after this hiking cycle ends. That certainly would be consistent with the 1990s.
The wildcard is the Fed’s reaction to the market’s message. Fed Chair Powell clearly wants to bring inflation down without damage to growth or employment. But the market is not giving that to him right now. The market expects the Fed to take the blunt instrument of fed funds hikes and stamp out inflation. Eggs and other things may be cracked. Powell seems to be looking at a choice between forging ahead against inflation or accommodating a market that may bring on a hard landing through its own repricing and tightening of conditions. Given that choice, Powell and others at the Fed seem resolute: inflation gets the nod.
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The view in rates
Yields have reversed course lately and dropped, with room on the long end to drop further. Fair value at 10-year and longer maturities still look solidly in the neighborhood of 2.50%, but market implied 10-year inflation remains high. The curve still should invert significantly over the next year with 2-year rates approaching 3.5%. Persistent supply and trade frictions from Russia-Ukraine could force the Fed to go higher than currently priced and push the 2-year note well above current forward rates.
The Fed’s RRP balances closed Friday at $1.86 trillion, flat week-over-week. The supply of Treasury bills continues to come down, and money market funds have little alternative but to put proceeds into RRP.
Settings on 3-month LIBOR have closed Friday at 141 bp, up 4 bp in the last week. Setting on 3-month SOFR have drifted up to 124 bp, up 6 bp in the last week.
The 10-year note has finished the most recent session at 2.92%, down 21 bp in a week. Breakeven 10-year inflation finished the week at 274 bp, down 12 bp on the week. The 10-year real rate finished the week at 19 bp, down 9 bp on the week. Real 10-year rates only recently have turned positive since the start of pandemic.
The Treasury yield curve has finished its most recent session with 2s10s at 34 bp, 5 bp flatter on the week, and 5s30s at 21 bp, steeper by 6 bp on the week.
The view in spreads
Spreads still look broadly biased to widen in both MBS and credit. Nominal MBS spreads will probably have to trade wider than the average investment grade corporate issue before it becomes compelling relative value for total return investors. Of the major spread markets, corporate and structured credit is likely to outperform, as it has generally since March 2020. Corporates benefit from strong corporate fundamentals and from buyers not tied to Fed policy—especially insurers. The credit markets have a diversified base of buyers while the only net buyers of MBS during pandemic have been the Fed and banks.
The view in credit
Credit fundamentals look strong for now but will almost certainly soften later this year as the Fed dampens demand and growth begins to slow. Corporations have strong earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. It will be important to watch inflation and see if costs begin to catch up with revenues. A higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumer balance sheets look strong with rising income, substantial savings and big gains in real estate and investment portfolios. Homeowner equity jumped by $3.5 trillion in 2021, and mortgage delinquencies have dropped to a record low.
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