Fed Chair Jerome Powell’s speech last Friday was a shock to the bond market. Even though the Fed (Powell and other Fed officials) had repeatedly said that the Fed would raise the fed funds rate to control inflation, the bond market (as shown by the Treasuries futures market) expected the Fed to raise the fed funds rate to 3.0% by early 2022 and then quickly pivot and begin to cut rates.
Now, it’s a different story.
**Inflation Bets Recede After Powell Speech**
**Fed chairman’s remarks last week have fueled wagers on sustained higher rates and more stable consumer prices**
**By Matt Grossman, The Wall Street Journal, Aug. 30, 2022 7:00 am ET**
**Four weeks ago, investors were betting that rates would peak early next year at less than 3.4%.**
**Now, trading in derivatives markets shows that traders think rates will be closer to 3.7% when the Fed convenes for its first meeting of 2023 in February. Moreover, bets are mounting that higher rates could endure into 2024.**
**In late July, just after the Fed raised rates to the current target range of 2.25% to 2.5%, traders were wagering that rates would briefly crest above 3% next year, but fall back into the 2% range during the summer. Now, the market is projecting interest rates will stay above 3% until November 2024....** [end quote]
By “rates,” the author means the overnight fed funds rate.
Longer duration bond yields are set by the market. The Fed is very gradually allowing its immense book of longer-term Treasury and mortgage bonds to roll off (mature without replacement). That removes money from the system, just as creating the money to buy these bonds in the first place added money to the system. Interest rates move opposite to bond prices. The longer the bond duration, the more the bond price changes with prevailing interest rates. The Fed’s gradual removal of their overwhelming QE has already cause longer-term yields to rise but not as quickly as the fed funds rate.
As the fed funds rate rises, the Treasury yield curve flattens and may invert. This is a signal of impending recession. Normally, the Fed would cut the fed funds rate to relieve a recession, but Powell has announced that they won’t do that until inflation has receded to a stable 2%. At that point, the Fed plans to hold a “neutral” rate of 2.5%.
The asset markets have adjusted their prices to an equilibrium based on ultra-low interest rates. All market will have to re-balance if the rates are neutral instead of negative REAL (inflation-adjusted) rates.
Corporate borrowers have to pay yields higher than the Treasury yields due to the risk of default. The spread between the corporate rates and the Treasuries is an indication of the bond market’s assessment of default risk.
The spreads of both investment-grade and junk bonds were suppressed by the Fed during the pandemic. Now the spreads are climbing to a more normal level. They are still well below a recessionary level but will climb if (when) a recession occurs.
Financial stress climbs. A spike is a sure sign of a crisis, but even a mild rise in financial stress can threaten weak companies. The Fed says that 10% of listed companies are zombies who can barely make their interest payments and may default if they have to refinance their maturing debts when interest rates are rising.
This is why many unprofitable “high growth” companies are hard-hit when rates rise. In their real-world operations and stock prices.
Jeff used to say, “Quality is always in style.” This is a good time to check your companies’ financial statements. Make sure they can cover their interest payments and dividends (if any) with plenty of room to spare. Low quality cash flow and earnings may cause a company to default.