Buckle Up for Continued Volatility

February 17, 2022

Source: Bloomberg Source: Bloomberg

So far, risk markets in 2022 have experienced numerous instances of elevated volatility. In recent weeks, we have seen the Federal Reserve (Fed) accelerate its timeline of raising rates and quantitative tightening. U.S. equity markets reacted quickly, with year-to-date declines almost 7% for the S&P 500 Index and over 10% for the NASDAQ Composite. Investment-grade (IG) corporate credit has seen spreads widen year-to-date by 16 basis points (bps), which is actually a rather resilient reaction. The Bloomberg IG Corporate Index, however, is already down almost 6% year-to-date. This is largely a function of the move higher in rates, with the 10-year Treasury yielding approximately 50 bps more than it was a mere six weeks ago.

Forecasts of Fed action range from four to seven rate hikes this year as well as balance-sheet reduction, all at a time when the Fed is still buying bonds. The likelihood of a 50-basis-point hike has increased for the March meeting as well. Meanwhile, the Treasury market is implying that the Fed is behind the curve in removing its accommodative stance, as the 2s10s Treasury curve continues to flatten sharply, now around 45 bps down from 155 bps less than one year ago.

This week’s chart shows the Bloomberg Corporate Index spread and duration, as well as the Federal Funds rate for the past 20 years. Note that spreads are near the recent tights experienced last summer. Meanwhile, the duration of the Bloomberg Corporate Index, the interest rate sensitivity, is still near recent record highs. Never before has interest rate risk in the IG corporate bond market been this elevated, and all at a time when the Fed and other global central banks embark on tighter monetary policy. The Fed is seeking to tame the elevated inflation readings, with the recent year-over-year Consumer Price Index reading up 7.5%, the highest rate since the early 1980s. Historically, the Fed has tightened in 25-basis-point increments, as indicated in the chart. A rate increase of more than 25 bps and/or balance-sheet reduction would seem to indicate that the Fed might be concerned about a policy error and trying to play catch-up.

While corporate earnings reports generally support continued deleveraging, inflationary effects are pressuring margins. Growth should remain supportive of IG corporate fundamentals in 2022, although concerns about a slowdown are increasing as the Fed deals with inflation. Last week’s consumer confidence reading likewise shows a cautious sentiment even as omicron eases.

Corporate bond spreads, although about 30 bps wider over the last three months and near the wides of 2021, have moved in an orderly fashion to this point. Investors are attracted to the cheaper spreads in IG markets and the more compelling yields, but there is justifiably little conviction that volatility will subside in the near term. Add in the increased Russia/Ukraine tensions and this hesitancy is certainly understandable.

Key Takeaway

While corporate credit spreads have widened, they are still about 50 bps inside of 2018 levels, with global demand for U.S. corporate bonds remaining steady. Although uncertainty regarding Fed action and the possibility of slowing growth are likely to weigh on spreads, I continue to see the longer duration as a greater risk at this point. More frequent episodes of volatility will further challenge current valuations. Should the Fed end up hiking rates six times this year, it would likely cause growth to be lower than forecasted, negatively impacting equity and credit markets alike.     

Tags: Volatility | Federal Reserve | Equity markets | Consumer Price Index (CPI) | Monetary policy | credit spreads | IG corporate credit

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