Central banks continue to face pressure to escalate the tightening of monetary policy. The US employment report for July shows no weakness in job creation, and wage growth appears to be far from peaking.
Taking this into account, markets now expect another 75-basis-point rate hike by the US Federal Reserve (Fed) at the next Federal Open Market Committee meeting in September, pushing the US yield curve into negative territory. In addition, the US Senate passed a USD 430 billion bill, formally known as the ‘Inflation Reduction Act’, over the weekend. A major part of the fiscal package is dedicated to climate and clean energy programme.
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How does the tightening of monetary policy impact the odds of a recession?
This suggests that a US recession is becoming more likely. In the past, safe-haven assets like US Treasuries have outperformed the S&P 500 in such situations. In the UK, the Bank of England has stepped up the pace of rate hikes by opting for a larger rate move than in previous meetings. Their focus has shifted extremely towards ‘do whatever it takes to break the inflation dynamic’, which is expected to accelerate further in the UK and reach over 12%. The Bank of England forecasts that the UK economy will start to contract in the last quarter of this year and shrink by more than 2% over the next 6–7 quarters. The unemployment rate may rise 2.6 percentage points and thereby bring inflation back to 2%.
Central banks’ dependency on data
We are still not convinced about the ambitious plans of central banks to slow down the economy in order to achieve lower inflation. Central banks have become highly data-dependent as economic volatility has increased. In addition, past policy tightening, increased bond yields, wider spreads, and lower share prices are just starting to have an impact on economic activity.
This will allow those central banks that have already delivered a lot in terms of front-loading rate hikes to reduce the pace of additional tightening. With a less hawkish Fed, the US economy will be in a better position to slow down without moving into a recession. In Europe, including the UK, it is fiscal-policy support that has the realistic chance of preventing those economies from slipping into the self-feeding loop of lower demand and higher unemployment, otherwise known as a recession.
How is credit being affected?
The first half of 2022 was terrible for corporate credit investors, as not only risk-free rates increased significantly but also widening credit spreads bit into fixed income portfolio values. In July and early August, however, we observed meaningful spread-tightening, allowing corporate bonds to regain some of their lost ground. This comes on top of lower benchmark yields since the mid-June highs as recession fears started to dominate the inflation debate. Some Fed members reminded the investment community last week that it is still determined to raise rates as long as needed to slow down demand enough to reduce price pressure.
However, even if there is a good chance that a full and deep recession can be averted (the latest strong US job report makes a recession hard to envisage), credit events are likely to pick up over the coming months. Tighter financial conditions make it more difficult, or at least more costly, for lower-rated companies to access the capital market.
Moreover, we expect the period when credit-rating upgrades dominate downgrades to end with the withdrawing of policy support. The performance picture points to a similar assessment, as the lowest-credit-quality bucket (i.e. CCC and lower-rated bonds) found it harder to benefit from the recent stabilisation in credit spreads.
Given the economic outlook and the continued need by the Fed to tighten financing conditions, we do not expect the weakest bonds to catch up anytime soon and to compress in spreads vs better-rated bonds. Meanwhile, we regard credit fundamentals as sufficiently solid so as not to unload all credit exposure.