The Daily Spark

There are around 2000 bonds in the HY index and roughly 16% currently trade at a yield higher than 10%, see chart below.

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.

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.

Predictably Bad Investments: Evidence from Venture Capitalists 

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4135861

Central Bank Communication with the General Public 

https://gceps.princeton.edu/wp-content/uploads/2022/04/wp291_Blinder-et-al_Central-Bank-Communication.pdf

Directed Search with Phantom Vacancies 

https://m.box.com/shared_item/https%3A%2F%2Fgeorgetown.app.box.com%2Fs%2Fvl8ns2kqfwn0mi8y2rl8hzksqugu2bon 

Consensus continues to downgrade growth expectations, and Treasury markets are starting to price a recession coming.  

This narrative in rates is in sharp contrast to the story being told in equity and credit markets, where the consensus has only revised down earnings expectations very modestly, see chart below.  

The bottom line is that rates investors and Fed watchers are getting increasingly worried about a coming recession, but equity investors are much more bullish and see little reason to downgrade earnings expectations meaningfully. 

Our chart book with daily and weekly indicators for the US economy is available here. 

Weekly data shows that a rising share of households say that they have difficulties paying their expenses, see chart below.

The costs of electricity for European households and firms are currently five to ten times higher than normal, and this is a serious risk to the outlook for Europe, see chart below.

With Walmart’s earnings out, the debate about the health of the US consumer is heating up again.

Wage growth is high, and job creation is strong, but inflation is starting to have a negative impact and trigger substitutions and changing consumption patterns.

From a rates and Fed perspective, what matters is growth in overall consumer spending. The top 60% of incomes account for almost 80% of total consumer spending, and with significant savings left among middle- and high-income households, it will take some time before overall consumer spending starts to slow down, see charts below.

The bottom line is that the Fed will have to raise rates more than the market expects to successfully cool the economy down. And faster Fed hikes increase the risk of a harder landing and deeper yield curve inversion.

Using the global BIS database, there are currently zero countries in the world with inflation below 2%, see chart below.

This fact raises the question whether US inflation is really something special driven by stimulus checks, higher unemployment benefits, and PPP loans.

Maybe the simple explanation is that inflation in the US is not driven by fiscal policy or even monetary policy, as our economics textbooks would say.

Instead, inflation went up literally everywhere in the world because of supply problems in the goods sector and in the energy sector. If this is the case, then inflation will soon come down once the supply chain problems in the goods and energy sectors have been resolved.

The bottom line is that with falling commodity prices and falling costs of transporting goods by container, truck, train, and air, we could see a sharp decline in inflation over the coming months. At least, the global nature of inflation seen in the chart below suggests that there is really nothing special about US inflation.

Dollar Funding Stresses in China

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4099944

IMF: Sharing the Pain of a Potential Russian Gas Shut-off to the European Union

https://www.imf.org/en/Publications/WP/Issues/2022/07/18/Market-Size-and-Supply-Disruptions-Sharing-the-Pain-of-a-Potential-Russian-Gas-Shut-off-to-520928

BIS: Big tech interdependencies – a key policy blind spot

https://www.bis.org/fsi/publ/insights44.pdf