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Connecting decision makers to a dynamic network of information, people and ideas, Bloomberg quickly and accurately delivers business and financial information, news and insight around the world
Americas+1 212 318 2000
EMEA+44 20 7330 7500
Asia Pacific+65 6212 1000
By Jack Pitcher, Alexandra Harris, and Alex McIntyre
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The world’s most powerful central bank is about to find out how far it can squeeze financial markets before something breaks. Struggling to tamp down the most pervasive inflation in decades, the Federal Reserve delivered its biggest interest-rate increase since 2000 last week while outlining a plan to begin unwinding trillions of dollars in asset purchases that have kept world markets brimming with cash since the 2020 crash. Its peers will soon follow suit. Bloomberg Economics has estimated that policy makers in the Group of Seven countries from the European Central Bank to the Bank of Canada will shrink balance sheets by about $410 billion combined in the remainder of 2022.
Yet it all comes at one of the most precarious times in recent memory for the global economy. Russia’s war in Ukraine, and the bevy of sanctions that followed, have upended business. Supply chains that were disrupted by the pandemic have grown even tighter, causing chaos for companies lashed by soaring prices for everything from labor to commodities. The worry now is whether central banks can accomplish the high-wire act of weaning Wall Street off unprecedented stimulus, without disrupting the flow of capital and tipping economies into recession.
Bloomberg News canvassed traders, money managers and analysts on their top market indicators to track corporate distress, liquidity shocks and cracks in the financial plumbing. We then analyzed decades of price history to identify the systemic turning points — when central bankers on a hawkish mission risk crashing the real economy.
While there’s little sign of widespread stress yet, some barometers of cross-asset health are moving closer to the danger zone. All that suggests investors are in for a bumpy ride as the Fed drains its unprecedented liquidity measures.
Here are four indicators keeping Wall Street worrywarts on edge.
Like it or not, the U.S. Treasury yield curve remains the top dog economic forecaster on Wall Street — even if the Fed’s bond-buying spree in the pandemic has distorted its message. In normal times, when the business cycle is in good health, the interest rate on debt maturing in, say, 10 years, will be higher than that on shorter-term securities as investors demand more compensation for the risk that inflation down the road will erode returns. If the opposite happens, meaning short-term rates are higher than the longer term, the foreboding dynamic is known as an inversion — signaling a bet that the central bank will eventually have to cut rates in order to salvage growth.
While not every inversion in the yield curve has led to a downturn, prolonged distortions have become eerily accurate, especially when two of the most widely followed curves become inverted at the same time, data compiled by Bloomberg show. Since the beginning of the 1990s, whenever yields on both 3-month Treasury bills and two-year notes have risen above the rate on 10-year bonds, a recession has followed almost without fail within the next six to 18 months. It’s a simplified measure — the most recent double inversion preceded a pandemic that no one saw coming — but big moves in yield curves have kept Wall Street on edge recently.
In late March and the start of April, the gap between two- and 10-year yields briefly inverted before normalizing, reflecting market angst that the Fed’s mission to aggressively tighten policy risks sparking a recession by ramping up the cost of money and thereby constraining consumer spending as well as business activity. At the same time, the spread between the three-month Treasury bill and the 10-year yield has been heading in the opposite direction, suggesting a still-healthy outlook for U.S. investment and consumption that gives the central bank room to make good on its policy-tightening plan.
Curve inversion happens when longer-term bonds yield less than shorter-dated paper
For now, yield-curve worriers are easy to find as the end of the easy-money era rocks global markets. Already this year, the Nasdaq 100 index of technology shares has had the worst start in decades, speculative stock strategies have lost billions and cross-asset volatility has spiked all over the world.
PGIM Chief Executive Officer David Hunt warned last week that signals in the bond market suggest a significant risk of a recession in 2024, while Citadel’s Ken Griffin said the outlook is the most uncertain since the global financial crisis.
U.S. companies have lost their ability to borrow money at ultra-cheap rates, a direct function of the Fed’s mission to cool the red-hot business cycle that’s stoked inflation for everything, everywhere all at once.
But when borrowing costs surge too far, too fast, the flow of corporate credit can become disrupted or even blocked entirely. In extreme instances, healthy companies can lose access to funding, wreaking economic havoc. This happened most recently during the onset of the pandemic, which forced the Fed to take unprecedented action to keep corporate America afloat.
The most widely followed credit gauge is the additional yield over Treasury bonds that investors demand to hold debt from the largest and strongest U.S. corporations. Currently, the spread on a Bloomberg index of U.S. investment-grade bonds has risen to 1.35 percentage points, from as low as 0.8 percentage point in June 2021, signaling higher borrowing costs that still sit below a key threshold for stress.
When the spread rises above 1.5 percentage points, it’s a warning sign that credit markets could seize up, making borrowing a lot harder, according to analysts and investors informally polled by Bloomberg. The metric has proved a reliable red flag in the past after crossing 2 percentage points in the volatile years after the global financial crisis and during the pandemic fallout.
To illustrate how the flow of credit across the entire U.S. economy can constrict, Bloomberg examined commercial and industrial loan data from all commercial banks, published monthly by the Federal Reserve.
The analysis, dating back to 1989, shows that when investment-grade credit spreads approach and exceed 2 percentage points, a threshold that’s been crossed just six times over that period, a contraction in loan growth almost always follows.
In January 2008, for example, borrowing costs for investment-grade companies soared to more than 2 percentage points for the first time in more than five years. Risk premiums remained above that level for nearly two years, and a prolonged slowdown in commercial and industrial loan volumes came next. Loan volumes fell for two years beginning in November 2008, causing historic damage to the world economy.
More recently, credit spreads spiked to over 3.5 percentage points in the March 2020 selloff. Yet some of the easiest borrowing conditions on record took hold in the following year as the Fed pumped liquidity into the financial system and even offered to buy corporate bonds directly.
Now premiums are back on the rise and company debt is becoming volatile. Investors and companies alike will be watching whether borrowing costs spike into risky territory that would disrupt the flow of credit once more.
Borrowers with weak balance sheets were given a reprieve after the Fed and other central banks rode to the rescue in the dark days of the pandemic. For the better part of two years, credit was dirt cheap and defaults became virtually non-existent. But the liquidity party is coming to a rapid end as interest rates rise — with new speculative-rated debt offerings this year falling to the lowest volume since 2009.
A recent bond sale from Carvana Co., for example, initially struggled to attract investors, and the used-car company ended up paying a whopping 10.25% yield while buyers demanded a clause intended to help shield them from losses if the company were to head to bankruptcy court. Similar cases abound.
A measure investors are watching closely is the extra risk premium that bond buyers demand to own debt from the lowest-rated companies compared to investment-grade peers. Call it the junk-bond penalty. When this premium goes up, it makes borrowing more costly and less accessible to issuers who need the funding the most, especially those who have poor credit ratings due to weak cash flows or high debt loads compared to their earnings.
If firms that have limited money on reserve and debt coming due in the near future lose access to primary markets, that makes defaults and bankruptcies more likely — bad news for growth-minded policy makers at the White House.
For most of the post-pandemic era, junk-rated companies across the globe paid little more to borrow than some of the biggest corporations — an average of just 2.4 percentage points more during 2021, a year that saw some of the easiest credit conditions ever, according to data compiled by Bloomberg. That made corporate failures exceptionally rare. But the tide is starting to turn. The junk penalty climbed above 3 percentage points last week. While that’s below the historical average of about 4 percentage points, the fast pace of liquidity tightening could soon cause trouble for the most vulnerable of companies. Since 2000, when the junk penalty has climbed above 5 percentage points and held above that level for an extended period, defaults have almost always risen above the historic norm, data compiled by Bloomberg show.
Investors’ worries over speculative-grade debt are often proven prescient after a lag.
The Fed’s massive pandemic stimulus program caused excess liquidity in the financial system to balloon, with banks flush with record cash in the form of reserves. Now, as the monetary authority begins to pare a $9 trillion balance sheet, a process known as quantitative tightening, Wall Street is on high alert for any resulting logjams in the financial plumbing.
When the Fed starts to shrink asset holdings — by simply not replacing maturing securities — there will be an increase in the number of Treasuries and mortgage bonds in search of a home in the private sector. And the amount of reserves held in the banking system will fall by design.
No one knows how any of this will ultimately play out. But the last time the central bank embarked on quantitative tightening, bad things eventually happened in late 2019. Banks saw their reserves fall sharply — fueling a disruptive spike in interest rates on so-called repurchase agreements, a keystone of short-term funding markets. That caused liquidity headaches all around and forced the central bank to intervene in the funding markets.
Bank reserve balances at the Fed have already started shrinking
The Fed has since implemented additional tools to help reduce these liquidity risks. But all bets are off. Some two and half years ago, total reserves held by depository institutions at the Fed slid to around $1.4 trillion. That was enough to cause liquidity issues in overnight lending, even though banks at the time considered $700 billion as the lowest threshold for comfort.
This time round, Barclays Plc estimates the tipping point at some $2 trillion versus $3.3 trillion currently. All this is guesswork with few historic precedents, so the reserve level will be a key focus for risk watchers well before it hits this point.
All in, traders around the world are bracing for a disruptive tightening in financial conditions on multiple fronts, from bonds and credit to money markets, as the Fed spoonfeeds markets with liquidity no longer.
“We have never been able to reduce inflation by more than 2 percentage points in the U.S. historically without inducing recession,” said Guggenheim Partners Chief Investment Officer Scott Minerd at the Milken Institute Global Conference in Los Angeles. “I think that it’s going to be really hard for the Fed to maneuver into a soft landing.”
