Volatility in Credit Markets: The Fed continues to push the accelerator

Volatility in Credit Markets: The Fed continues to push the accelerator

Global credit markets have experienced several years of heightened volatility following the historic increase in interest rates over the past two years, and it doesn’t seem to have reached its conclusion yet. The Federal Reserve, in its efforts to combat inflation and cool the American labor market, continues to raise interest rates, directly impacting the credit market. Despite credit conditions improving earlier this year after the Silicon Valley Bank’s bankruptcy and the liquidity injection by the U.S. Treasury, recent weeks have seen a return of volatility, with the yield on U.S. blue-chip bonds reaching 6.15%, the highest levels in the past year. Speculative-grade borrowers are also feeling the pressure as junk-bond spreads are at their highest since the end of June, yields have surged above 9% due to rising Treasury rates.

Current macroeconomic indicators portray a robust American economy, with record-low unemployment rates, rising inflation, a strong real estate market, and high consumer spending. Therefore, the Fed has yet to find sufficient reasons to halt the interest rate hikes. However, leading indicators suggest that the American economy is cooling down. On the one hand, industrial indicators indicate a slowdown in demand. On the other hand, all the savings accumulated by households from the COVID lockdowns until now appear to have been depleted, leading to a surge in credit consumption. Another crucial factor to consider is that companies do not feel the impact of interest rate hikes until a year later when they need to renew loans or credit lines.

The big question is how far the Fed can go with interest rate hikes without damaging the American economy. It is evident that the rate hikes are nearing their end, as the Fed has limited room for further increases. Going beyond this point would be against U.S. interests as it would entail paying significantly higher interest rates on its debt, jeopardizing its real estate market and businesses’ ability to borrow at such high levels. Market sentiment suggests that, despite the hikes nearing their end, they might last longer than expected and extend over time. Thus, a credit market recovery akin to what occurred during the COVID lockdowns seems unlikely without a market shock prompting immediate action from the U.S. Treasury and the Fed.

It is likely that in the short period, the global credit market will continue to experience significant volatility until central banks, especially the Fed, shift their monetary policies back to expansionary measures involving QE programs and rate cuts. For such circumstances to materialize, the economy must cool down, potentially entering a recession, and inflation must decrease to levels close to the Fed’s target of 2%. On the flip side, investors may benefit from this situation by finding attractive yields in the corporate market, particularly from companies with the capacity to service these bonds, offering returns not seen in years.