Chart Of The Week: Fed Vs. Credit

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Includes: ACP, AIF, ANGL, ARDC, BSJP, CIF, CIK, CJNK, DHY, DSU, EAD, FALN, FHY, GGM, HIX, HYDB, HYG, HYIH, HYLB, HYLD, HYLS, HYT, HYUP, HYXE, IVH, JNK, JQC, JSD, KIO, LQD, MCI, MPV, NHS, PCF, PHT, SJB, UJB, USHY, VLT, WFHY
by: Topdown Charts
Summary

US high yield credit spreads have fallen to post-crisis lows.

The Fed is continuing to tighten monetary policy.

Typically, these two factors do not produce the best outcomes for credit investors, as tighter policy ultimately leads to wider credit spreads.

This week it's two very topical developments on the one chart. The Fed has delivered yet another rate hike and shows no signs of slowing down, and importantly - high yield credit spreads have moved to new post-crisis lows.

The chart comes from a report on the Fed and markets, in which we addressed the wider issues for the Fed and risk assets.

As noted, the chart shows credit spreads moving lower and the Fed funds rate moving higher.

credit spreads vs the Fed

Specifically, we're looking at US high yield credit spreads (aka junk bonds), which is basically a market based measure of credit risk pricing. The level of the US Federal Reserve's key benchmark should be familiar. My arrows are added in for emphasis of the typical pattern.

That typical pattern is that Fed rate hikes are usually eventually followed by widening credit spreads. This makes economic sense from the point of view that interest rate hikes are basically a sign of the maturity of the economic cycle, and when they come too much and too fast they can even precipitate the ending of an economic cycle. Clearly, credit risk falls in boom times and rises in recession as defaults surge.

The issue is, as you can see on the chart, the lag time can vary substantially between the beginning of a hiking cycle and a subsequent blowout in spreads. In some cases, it came very rapidly e.g. 2015 and the late 1990's. Meanwhile, in the mid-2000's, credit spreads actually tightened in the face of an extended cycle of rate hikes. And now it seems the cycle is repeating.

So while there are many factors driving credit spreads (we track about a dozen key variables), Fed rate hikes have historically been a key risk driver, and each additional rate hike brings the day of reckoning closer for high yield credit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.