Commentary:
One of the things that have been unusual about recent market moves is that credit spreads has not been tightening with the move up in global risk free yields. Here is a chart of the US long term BBB yield vs the 30yr Treasury yield. Note that unlike what happened during the Taper Tantrum, where credit spreads were broadly stable or even tightened, over the past 6 months, spreads have unambiguously widened.
Now this type of behavior is not uncommon heading into recessions, after the Fed has already tightened. But that is not the case here – very few macro indicators suggest such a risk is yet on the horizon.
This widening in spreads has been a surprise to the consensus, which has broadly expected the usual pattern of credit yields being broadly stable in treasury sell offs. When combined with the fact that equity prices has not appreciated much, the result is that financial conditions (there are many ways to measure it – I used the Chicago Fed measure below) has tightened to unusually restrictive levels. In fact, these levels are usually only seen just ahead of recessions & slowdowns, and coincident with local highs in treasury yields:
Now, you may ask, does it really matter? Or worded differently: does the Fed care?
I think the answer is: probably. The FOMC centrists have noted repeatedly that they are concerned about the risks to financial asset prices (and knockon effects on the real economy) following the first hike. Given how tight financial conditions (and reportedly low fixed income liquidity) are currently, one would think that would influence FOMC thinking. And this is all before the recent weak data is taken into account.
There is a rough historical analog to rates movements the past few years. The Treasury price action following the Savings & Loan crisis resulted in a sharp fall in treasury yields, a Fed ‘mistake tightening’ cycle in 1994, which was then subsequently unwound. The movements in the long end over that period and now bear many similarities, but the comparison from late 1993-1997 (in red) and now (in blue) are somewhat eye-catching:
It appears that back in 1996, equity prices were broadly range bound until it became apparent that yields had topped by 3Q. After that, it was off to the races. The analog to the 2015 price action is below:
In aggregate, it may be that like in 1996, financial markets are waiting for financial conditions (proxied by this global bond sell off) to stabilize. Credit spreads and other risk premia may not tighten until then.
Having said that, we may be nearing that point. I’ve already noted that historically, financial conditions at these tights have coincided with local tops in treasury yields. Ultimately, it will still be the data that will drive the Fed’s decision for lift off. But note that the last Fed guidance ‘ease’ was in March. Data since then has continued to disappoint, even as Fed Funds pricing has been range bound. (BBG US economic surprise index in white, the Dec 2015 Fed Funds Futures implied yield in orange) This suggests that the current market pricing of a 25bp move up in the effective Fed Funds rate by Dec is fairly reasonable:
Given that consensus expectations for Fed Funds in 4Q is 70bps, a SEP next week pointing to a Dec or later lift off is likely to be supportive for treasury prices, and potentially credit and equities as well.