Corporate Bond Market Distress

The New York Fed measure of corporate bond market distress is starting to flash red for IG, see chart below. Specifically, the New York Fed corporate bond market distress index is calculated using FISD data on issuance volumes and primary market pricing as well as issuer characteristics.

For the secondary market, the index uses trading data available through TRACE and includes measures that reflect both the central tendencies, and other aspects of the distributions, of volume, liquidity, nontraded bonds, spreads, and default-adjusted spreads. Finally, the index also uses quoted prices from ICE BoA to capture the differential secondary market conditions for traded and non-traded bonds. For more see also here.

NY Fed measures of corporate bond market distress
Source: FRB of New York, Apollo Chief Economist Note: The CMDI index offers a single measure to quantify joint dislocations in the primary and secondary corporate bond markets. Ranging from 0 to 1, a higher level of CMDI corresponds with historically extreme levels of dislocation. CMDI links bond market functioning to future economic activity.

The Fed’s Models for R-Star

The Fed is trying to tighten financial conditions to cool down inflation, and they do this by raising the Fed funds rate. And the Fed’s models find that the neutral Fed funds rate where monetary policy is neither accommodative nor restrictive is when the Fed funds rate is 2.5%, which is where the Fed funds rate is today. Last week, the Fed argued that with the Fed funds rate now at neutral, they would drop forward guidance and instead be flexible meeting-by-meeting.

The analytical challenge is that the models estimating r-star, or the neutral Fed funds rate, only include one interest rate, namely the Fed funds rate, and don’t include the true costs of capital for firms and costs of borrowing for households such as the yields on IG, HY, and loans, and also the level of the S&P500 for companies, and the costs of borrowing on auto loans and credit cards and mortgages.

Put differently, the Fed funds rate can be at 2.5% and S&P500 at 3000, and HY spreads at 10%, and this would probably not be considered neutral.

Similarly, the Fed funds rate at 2.5%, S&P500 at 5000, and HY spreads of 3% would probably be regarded as easy financial conditions.

The bottom line is that the assumptions going into the academic models estimating the neutral Fed funds rate are simply too far away from the real world to make their estimates of r-star useful. With equities and credit now rallying, the bottom line is that the true r-star is higher, which is a different way of saying that to successfully cool the economy down, the Fed will likely have to raise rates more than the market is currently pricing.

Chart showing that financial conditions may be easing.
Source: Bloomberg, Apollo Chief Economist

Rate Cuts Ahead?

Last week there were two important developments for markets. First, we had the FOMC meeting, which resulted in a 75-basis points interest rate hike. Secondly, new GDP numbers generated a lot of attention, showing two consecutive negative quarters of GDP growth—which is normally described as a recession. However, at the same time, some important data points continue to show signs of strength—with the labor market looking especially resilient. That brings us to the July employment report, which will be released this Friday. The consensus expects the US unemployment rate to remain at a low 3.6%, unchanged from June. A steady level of job growth is also anticipated. Despite strong job numbers, speculation is building that perhaps the Fed will begin to cut rates as soon as the first quarter of 2023, shifting their focus away from inflation and over to growth. Historically speaking, there have been points in time when the central bank has cut interest rates even when inflation is above their 2% target—so this move would not be unprecedented.

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