Fed's monetary policy shift is finally taking hold. It just took a while.
The weekly St. Louis Fed Financial Stress index, released today,
just spiked beautifully. It had been at historic lows back in November,
an expression of ultra-loose financial conditions in the US economy,
dominated by risk-blind investors chasing any kind of yield with a passion,
which resulted in minuscule risk premiums for investors and ultra-low
borrowing costs even for even junk-rated borrows. The index ticked
since then, but in the latest week, ended February 9, something
happened:
The index, which is made up of 18 components (seven interest
rate measures, six yield spreads, and five other indices) had
hit a historic low of -1.6 on November 3, 2017, even as the
Fed had been raising its target range for the federal funds
rate and had started the QE Unwind. It began ticking up late last
year, hit -1.35 a week ago, and now spiked to -1.06.
The chart above shows the spike of the latest week in relationship
to the two-year Oil Bust that saw credit freeze up for junk-rated
energy companies, with the average yield of CCC-or-below-rated
junk bonds soaring to over 20%. Given the size of oil-and-gas
sector debt, energy credits had a large impact on the overall average.
The chart also compares today's spike to the "Taper Tantrum" in the
bond market in 2014 after the Fed suggested that it might actually
taper "QE Infinity," as it had come to be called, out of existence.
This caused yields and risk premiums to spike, as shown by the
Financial Stress index.
This time, it's the other way around: The Fed has been raising rates
like clockwork, and its QE Unwind is accelerating, but for months markets
blithely ignored it. Until suddenly they didn't.
This reaction is visible in the 10-year Treasury yield, which had been
declining for much of last year, despite the Fed's rate hikes, only to
surge late in the year and so far this year.
It's also visible in the stock market, which suddenly experienced a
dramatic bout of volatility and a breathless drop from record highs.
And it is now visible in other measures, including junk-bond yields
that suddenly began surging from historic low levels.
The chart of the ICE BofAML US High Yield BB Effective Yield Index,
via the St. Louis Fed, shows how the average yield of BB-rated
junk bonds surged from around 4.05% last September to 4.98%
now, the highest since November 20, 2016:
But a longer-term chart shows just how low the BB-yield still
is compared to where it had been in the years after the
Financial Crisis, and how much more of a trajectory it might
have ahead:
When yields rise, it means that bond prices are dropping. And
so the selloff that has been hitting the Treasury market is finally
creeping into the riskier parts of the corporate bond market,
which had been in denial of the Fed's efforts to tighten financial
conditions via rate hikes and the QE Unwind.
The Financial Stress Index is designed to show a level of zero
for "normal" financial conditions. When these conditions are easy
and when there is less financial stress than normal, the index is
negative. The index turns positive when financial conditions are
tighter than normal.
But at -1.06, it remains below zero. In other words,
financial conditions remain extraordinarily easy. This is clear
in a long-term chart of the index that barely shows the recent spike,
given the magnitude of prior moves:
This is precisely what the Fed wants to accomplish. The market is
just slow in reacting to a shift in monetary policies. But when
it begins to react, the adjustment can be sudden and large. Given
that the Fed wants to "normalize" financial conditions – where
these kinds of measures return to normal levels – there will have
to be quite a bit more tightening in the markets before the market
catches up with the Fed's intentions. And the Fed itself is likely
behind the curve – in which case it too will have to do some
catching up. So these adjustments in yields and prices are coming.
And yesterday's reports didn't help at all.
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