The Daily Spark

The high and rising share of small-cap companies with negative earnings makes middle-market companies more vulnerable as the Fed keeps interest rates higher for longer, see chart below.

Imports are falling, and this normally only happens when the economy is in a recession, see chart below.

The weakness in the goods sector is offset by continued strength in the less interest rate-sensitive service sector, which makes up 80% of GDP.

There are a total of 45 million people with student loans, and the average monthly student loan payment is around $200. So resuming student loan payments in October will subtract roughly $9 billion from consumer spending every month, or roughly $100 billion a year, and this will mainly have an impact on younger households, see chart below.

Total employment in the US economy is currently around 156 million, and we estimate that total employment of companies in the high yield index is 11 million, and total employment of companies in the leveraged loans index is 8 million, see chart below. With interest rates staying high for at least another year, the downside risks to employment continue to be meaningful.

With yields going up in Japan, the risk is that Japanese investors will now begin to sell US fixed income and start buying higher-yielding Japanese fixed income.  

This is a big deal for global fixed income markets because Japanese investors are the biggest foreign holder of US Treasuries, and they also own significant amounts of US credit.

Our updated BoJ YCC exit chart book is available here, a few key stats:

• Japan is the largest holder of US Treasuries in the world, see the first chart below.
• The BoJ owns more than 50% of all JGBs outstanding, see the second chart.
• BoJ JGB buying has been a dominant force in markets for the past decade, see the third chart.
• Because of the significant yield differences in the front end of the yield curve between the US and Japan, the hedging costs for Japanese investors buying US Treasuries are very high at the moment, see the fourth chart.
• Also, this BoJ illustration of their policy change shows how they will now do “YCC with greater flexibility.”

All other central banks in the world, including the Fed, ECB, BoE BoC, and RBA, have aggressively raised short-term interest rates to get inflation under control. The BoJ has not raised short-term interest rates, and abandoning YCC is the BoJ’s response to high inflation. The BoJ YCC policy started in 2016.

The Fed has used the Taylor Rule framework for decades to understand what the Fed funds rate should be, and inserting the current level of inflation and unemployment into the Taylor Rule shows that the Fed funds rate today should be 9%, see chart below and our Daily Spark here.

The ongoing gap between the Fed funds rate predicted by the Taylor Rule and the actual Fed funds rate raises the question whether the Fed remains behind the curve. In other words, if the economy reaccelerates over the coming quarters with higher consumer spending and a boom in housing, it will increase the risk that the Taylor Rule was right and that the Fed will have to continue hiking. 

In sum, for markets to continue to trade higher, the soft landing must be a soft landing, not a reacceleration, because if housing and consumer spending accelerate from here, the Fed will have to raise rates a lot more.

Fed hikes continue to slow down hiring for both small firms and for the broader economy, see charts below. The labor market is softening with hours worked, the number of job openings, and the quits rate all declining.

This is how monetary policy works; higher costs of capital slow down capex spending and hiring, and with rates staying at these levels for a couple of years, this process is going to continue.

That is why the consensus expects negative nonfarm payrolls for six months from October 2023 to March 2024.

Since the Fed started raising interest rates, we have seen an increase in downgrades of loans and a rise in the share of loans trading at distressed levels, i.e. below 80, see charts below. This is the monetary policy transmission mechanism at work; higher costs of capital are having a negative impact on the economy.

Markets are not taking the ongoing rise in default rates for HY and loans seriously, see charts below, and many investors argue that “this is just a normalization,” or “these are companies nobody has heard about.”

The reality is that more and more companies are defaulting because the cost of capital is higher, and Fed Chair Powell says that interest rates will stay at these levels “for a couple of years,” so tight monetary policy will continue to have a greater negative effect on the economy and capital markets.

In fact, higher costs of capital is precisely how monetary policy works: By making it more difficult to get financing.

In other words, Fed hikes are biting harder and harder, and all investors should have a view on how high they think default rates will go during this cycle, see again charts below.

What could be the aha moment in markets? Once there is a default by some household name in credit, we will likely see an overnight change in market sentiment from bullish to bearish.

China accounts for more than 50% of global coal consumption, see chart below.