Rates and the Fed: Unconventional wisdom

Mid Week Bond Update

Rates and the Fed: Unconventional wisdom

In the wake of the Fed’s decision on Wednesday afternoon, it’s useful to step back and take a broad view of how the central bank’s policy moves could impact interest rates in the long run.

Certainly, the Fed’s moves must be considered in the context of broader forces, including the credit cycle.  Consider the case put forth by Brandywine Global’s Francis Scotland that the FOMC’s quantitative easing campaigns since the 2008 global financial crisis (GFC) were a less powerful force pushing down rates than the combination of several macro issues: namely the European Sovereign Debt Crisis, China’s attempt to reduce the leverage that underpinned its economy, the commodity and energy bust, and a variety of geopolitical crises, not the least of which is Brexit – all of which were deflationary and would presumably act to depress yields rather than boost them.

Scotland notes that the onset of each QE-spawned expansion of the Fed’s balance sheet was associated with a rise in U.S. Treasury yields rather than a fall, at least in the early phase (see chart below), with yields higher at the end of the effort than at the beginning.


Chart: Bond Yields Ended Higher After Every Episode of QE

Chart Courtesy of Brandywine Global. Source: Macrobond, as of 9/30/2018. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Instead, Scotland suggests that growth of credit in the economy is the key variable the Fed should be monitoring when it comes to the pace of shrinking its  balance sheet – a figure that for now is less than inspiring.

For more, insight, read Watch the Fed's Balance Sheet
 

On the rise:  HY Energy Spreads vs. HY Overall Spreads

The rapid pickup in high-yield corporate spreads[1] since the beginning of October (with the average up 144 bps to 4.47% between October 3 and December 17) is no longer newsworthy.  But it’s worth noting that the damage has a sector-specific spin.  Specifically, a disproportionate share of the credit – or blame – goes to the high-yield energy sector, whose spread during the same period jumped 234 bps to 5.86%.[2] At the same time, the average spread of U.S. investment-grade corporates rose – but by a much more moderate 36 basis points. It’s noteworthy that crude oil prices started their current plunge on the same date – October 3 – and are now lower by some 34.7% (Brent crude) and 39.5% (WTI crude).

One reasonable conclusion: for the most part, the energy sector is driving overall high-yield spreads.  If there’s a more general issue in the U.S. credit markets, it’s much less pronounced.

 

On the slide: Italy-Germany spreads

With their front pages now focused on other matters, the tension in Europe’s bond markets regarding Italy appears to have waned. From its peak of 327 bps on October 18, during the height of the test of will between Italy and the European Union over Italy’s budget projections, the spread between Italian and benchmark German 10-year government bonds has fallen to about 269 bps.

The move reflects the reality that the European Union’s overall budget crisis involves countries other than Italy and is far from resolved.  In addition, there’s talk in Italy that the government is getting ready to submit a budget that is – at least technically – within the required parameters of the EU.

Of course, one could argue that France is now challenging Italy for the role of most politically charged major EU country, with persistent Yellow Vest protests causing President Emmanuel Macron to back down from some budget-friendly tax and wage proposals, with no apparent end in sight for additional concessions to clear the streets. The pickup in spreads has been minor so far, from 65 bps before the protests began to as high as 73 bps on December 17. But since both the overall EU budget process and France’s political troubles look to have long tails, the story is far from over.

 


[1] All figures based on the Bloomberg Barclays indexes for their respective credit sectors.

[2] Source: Bloomberg, December 17, 2018 4:00 PM ET

Definitions:

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System (Fed) responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

One basis point equals one one-hundredth of one percentage point. One hundred basis points is equal to one percentage point.[1] All figures based on the Bloomberg Barclays indexes for their respective credit sectors.

[2] Source: Bloomberg, December 17, 2018 4:00 PM ET

 

[1] All figures based on the Bloomberg Barclays indexes for their respective credit sectors.

[2] Source: Bloomberg, December 17, 2018 4:00 PM ET

 
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