We all know that inflation is at a 40-year high and this is public enemy #1 that the Fed must slay. Fed Chairman Jerome Powell repeatedly this year has brought up the famous Fed Chair of the 1970s, Paul Volker, who pushed the US economy into multiple recessions to squash inflation. As of now, the primary concern for the public is by far inflation, not recession risk, and not the risk of a bear market in stocks given news headlines as a gauge of importance.
The Fed must run the fine line between fighting inflation and killing the economy. Volker was not as concerned about killing the economy in the fight against inflation but, to be fair, he also didn’t have a US financial system as leveraged with debt that we do now.
Remember October 2008 when there was a run on the money market system? We had a complete freeze of the commercial paper market to the point where General Electric couldn’t even pay its employees and Jeff Immelt personally called US Treasury Secretary Hank Paulson to discuss what was happening. As financial pundits say, the Fed pushes until something breaks and then comes riding to the rescue. Given inflation remains public enemy #1, and we haven’t yet had a clog in the US financial plumbing system, the Fed is likely to continue attacking inflation and not provide the market any relief…yet. As a guide for how things may proceed in the month ahead, consider three major plumbing issues in the past 5 years on what “broken” looks like, and what it ultimately took for the Fed to step back in.
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The 2018 Market Upheaval
When Powel in 2018 was raising rates and shrinking the Fed’s balance sheet, financial conditions began to tighten and the peak stress was seen in December of 2018. Prior to then, the junk bond market saw new issuance running at roughly $10-20 billion a month but in December we had a complete seizure where not a single deal was able to be completed. The junk bond issuance drought went on for forty days until Targa Resources Partners LP was able to sell $1.5B in debt according to the Wall Street Journal (Junk-Bond Sale Ends 40-Day Market Drought, 01/10/2019).
As of May 18th, we are starting to see junk bond new issuance slowing where so far only $2.157B in debt has been issued where 99% of that came through Monday the 9th. In the last 9 days, the only deal to get done was a $20M deal by Ford Motor Credit. Unless the freeze since last Monday ends, this will be the fewest amount of deals (5) and lowest issuance of new debt for any May in the last 12 years.
While the junk bond market is clearly starting to show signs of slowing to a crawl, there is no mention of this in the news headlines and this is not yet front-page news with which the Fed must address. The seizure in 2018 started at the beginning of December when no more deals occurred, and we didn’t get the “Powel Pivot” until a month later on the first week of January 2019 when Powell said he would use all tools available to address financial markets and the economy and wouldn’t hesitate to act. So far, unless new junk bond market deals occur in the near future, the present date for the junk bond seizure is May 16th when the last deal occurred. We may have to wait weeks for this seizure to build to front page news and catch the Fed’s attention. So, we are close to the “breaking point” in corporate junk debt markets, but not yet at a Fed pivot.
There isn’t any hint from the Fed of relenting as Powell last week mentioned how it would be appropriate to raise the Fed funds rate by 50 bps at the next two meetings and this week said the Fed was willing to go above the neutral rate, the rate which neither stimulates or contracts the economy. Thus, the Fed is communicating it is willing to contract economic growth for the sake of beating back inflation. Further, while issuance is slowing dramatically, the market itself has yet to panic as evidenced by credit spreads and we always get a market panic before a Fed panic. Current spreads such as the LIBOR-OIS spread (orange line) or commercial paper spreads (blue line) are nowhere close to the levels seen in 2018 or during the March 2020 market seizure events.
The 2019 Market Upheaval
The other panic moment when something broke by the Fed shrinking its balance sheet was the September 2019 repo crisis where overnight refinancing rates spiked dramatically over the federal funds rate to levels not seen since 2008. That was enough to get the Fed’s attention where they quit shrinking their balance sheet and immediately started the printing presses with the spike shown below.
I won’t go into the March 2020 Covid-induced market upheaval, but that was the other event in the last few years where the Fed responded to market dislocations.
With financial markets not quite near seizure levels, we do not appear to be close to a Fed pivot yet. Further, the other concern given the decline in economic growth (negative print in GDP for Q1 2022) is that analysts continue to not price in any potential economic weakness for corporate earnings where 12-month forward estimates for S&P 500 earnings per share remain near their highs with no hint of discounting any economic weakness.
The prior tightening seen in financial markets (10-yr UST yield jump) will likely weigh on future growth as measured by the ISM New Orders Index well into the early part of 2023. This forward-looking economic indicator foretells a coming economic slowdown that has not been priced into market expectations one bit. If Wall Street analysts haven’t capitulated on their rosy forward expectations, why would the Fed capitulate?
We may be in store for an oversold relief rally, but I think it remains premature to say we have hit the bottom as there is no clear indication we are at the max pain threshold for the Fed to intervene and believe investors still need to remain in a defensive posture.
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Copyright © 2022 Chris Puplava
