The Daily Spark

The term premium is up one percentage point since late July, see chart below showing that the ongoing rise in long rates is driven less by changing Fed expectations and more by:

1) The US sovereign downgrade

2) Japan exiting YCC

3) Fed QT

4) Fewer dollars for China to recycle in a falling exports environment

5) The US budget deficit

6) The large stock of T-bills and the Treasury’s intention to increase auction sizes.

Looking ahead, the real risk to the economy, including financial stability, is if weak economic data doesn’t result in falling long-term interest rates. The Treasury market’s reaction to the employment report next week will be very important and likely set the tone for markets in Q4.

The last Fed hike was in July.

If this was the last Fed hike during this cycle, and assuming it takes on average eight months from the last Fed hike to the first Fed cut, then the Fed will start cutting rates in March 2024, see chart below.

The big difference today is that inflation remains significantly above the FOMC’s 2% target. This may lead the Fed to keep rates high, even if the economic data starts to slow down more meaningfully.

The index of VC-backed IPOs is down 50% since last year when the Fed started raising interest rates, see chart below.

Similarly, Nasdaq 100 and Russell 2000 Growth are down 10% and 20%, respectively.

With interest rates permanently higher, venture capital and growth will likely continue to underperform.

Consensus expectations show that the market is expecting Europe to be in stagflation in 2023 and in 2024, see charts below.

The classic textbook response to stagflation by the central bank is to keep interest rates high until inflation is under control and then wait for growth to eventually restart.

This is also what we should be expecting from the ECB. The implication for markets is high short rates and low growth in earnings.

The CCC spread in Europe is normally very highly correlated with the CCC spread in the US. But this relationship has changed after the Fed started raising rates, see the first chart below. 

Spreads are currently pricing that Europe will have a recession with many defaults, but in the US, everything is fine. 

The rally in the US relative to the EU has happened despite the consensus seeing a 60% probability of a recession in the US over the next 12 months and only a 50% probability in Europe, see the second chart.

The bottom line is that there is an inconsistency in pricing of lower-rated corporate credit in the US and Europe. We cannot both have that everything is fine and at the same time we are going into a recession. 

The key question is why US credit has rallied so much despite the high recession probability. Given the relationship changed after the Fed started raising rates maybe the reason is what could be called a yield level illusion in US lower-rated credit, where investors focus more on the levels of yields than on the underlying fundamental credit risks of Fed hikes and permanently higher costs of capital.

In short, credit investors today should be asking themselves if spreads are focusing on yield levels or on credit fundamentals.

The seven biggest stocks in the S&P500 are up more than 50% in 2023, see chart below.

The remaining 493 stocks are basically flat.

The bottom line is that if you buy the S&P500 today, you are basically buying a handful of companies that make up 34% of the index and have an average P/E ratio around 50.

Since the Fed started hiking rates last year, US households have bought $1.5 trillion in Treasuries, and over the past six months, US pension and insurance have also emerged as a buyer, see chart below. Over the same period, the Fed has been doing QT and been a net seller of Treasuries. The bottom line is that US households and real money are finding current levels of US yields attractive.

The Business Roundtable CEO survey is designed to provide a picture of the future direction of the US economy by asking CEOs to report their company’s expectations for sales and plans for capital spending and hiring over the next six months.

Since the Fed started raising rates in March 2022, CEOs have gradually worried more and more about the economy slowing, see chart below.

This is how monetary policy works. Higher cost of capital slows down business spending. The decline in the employment sub-index to 2020 levels is particularly noteworthy.

Our monthly credit market outlook is available here, and the three key themes for investors are 1) Up in quality, 2) Large cap, and 3) Low leverage and high interest coverage ratios.

With the Fed on hold well into 2024 and the maturity wall coming, debt refinancings will continue to come in at higher levels of yields, see the first chart below.

The bottom line is that the cost of capital has increased significantly, and Fed hikes are biting harder and harder, particularly for companies with weak credit fundamentals.

Slowing global growth would argue for falling commodity prices. That is also what we are seeing for industrial metals such as copper.

Slowing global growth combined with extreme weather and inventory situations have created a more mixed situation for agricultural commodities. The agriculture price index has been moving sideways, with some components (such as orange juice, cocoa, and sugar) going up and others (such as soybean, corn, and coffee) going down.

For energy, slowing global growth and rising US production would argue for lower oil prices. But OPEC+ production cuts have pushed oil prices higher in recent months.

The sideways movement in the broad commodity price index is likely a welcome development for the Fed. However, a continued rise in oil prices could magnify the ongoing slowdown in growth and reverse the ongoing decline in inflation.

Our latest outlook for commodity prices is available here.