The market red flags that could prompt the Fed to slow the pace of rate hikes

(Bloomberg) — Strategists are looking beyond the key inflation issue to other potential market indicators that could prompt the Federal Reserve to slow its aggressive rate hike cycle.

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Dismal August US consumer price data last week bolstered bets for a third straight 75 basis point move when the central bank makes its next decision on Wednesday. Slowing inflation aside, other potential indicators that could prompt policymakers to shed their pessimism include wider credit spreads, rising default risk, shrinking bond market liquidity and growing currency turmoil.

Here are a number of charts that look at them in more depth:

The difference between the average yield on U.S. investment-grade corporate bonds and their risk-free Treasury counterparts, known as the credit spread, has jumped about 70% in the past year, driving up the cost of borrowing for businesses. Much of the increase came as annual U.S. inflation data beat forecasts, shown as green flags in the chart above.

Although spreads have fallen from their peak of 160 basis points in July, the increase underscores the mounting stress on credit markets from monetary tightening.

“Investment-grade credit spreads are the most important metric to watch given the large share of investment-grade bonds,” said Chang Wei Liang, macro strategist at DBS Group Holdings Ltd. in Singapore. “Any excessive widening of investment-grade credit spreads above 250 basis points near the peak of the pandemic could prompt more nuanced policy guidance from the Fed.”

Higher borrowing costs and a drop in stock prices since mid-August have tightened U.S. financial conditions to levels not seen since March 2020, according to a Goldman Sachs benchmark of credit spreads, stock prices, interest rates and currencies courses. The Federal Reserve is closely monitoring financial conditions to gauge the effectiveness of its policy, Chairman Jerome Powell said earlier this year.

Another indicator that could spook the Fed is a surge in the cost of protecting against the risk of corporate debt defaults. The spread on the Markit CDX North America Investment Grade Index, a benchmark for credit default swaps on a basket of investment-grade bonds, jumped by the biggest margin in a year on Tuesday. The spread has doubled since early January to about 98 basis points, approaching its 2022 peak of 102 basis points set in June.

Rising default risk is closely linked to the rising dollar, which is benefiting from the rapid pace of interest rate hikes by the Fed.

Another threat that could cause the Fed to slow the pace of tightening is a tightening of Treasury liquidity. Bloomberg’s index of US Treasury liquidity is near its worst level since trading was effectively halted due to the start of the pandemic in early 2020.

The depth of the market for U.S. 10-year Treasuries, as measured by JPMorgan Chase & Co., also shrank to levels last seen in March 2020 as traders struggled to find prices for even the most liquid government debt securities.

Poor liquidity in the bond market would increase pressure on the Fed’s efforts to reduce its balance sheet, which has grown to $9 trillion through the pandemic. The central bank currently lets $95 billion of government and mortgage bonds slide off the balance sheet each month, removing liquidity from the system.

A fourth area that could cause the Fed to think twice is the growing turmoil in currency markets. The dollar has rallied ahead this year, setting multi-year highs against nearly all of its major peers and pushing the euro below parity for the first time in nearly two decades.

The U.S. central bank usually ignores the dollar’s strength, but an excessive fall in the euro could fuel fears of a deterioration in global financial stability. The common currency extended losses earlier this month, but its relative strength index, or RSI, did not. This suggests that its downtrend may be slowing, but the bulls will need to push it back above its long-term downtrend line to challenge the bearish regime.

Escalating rhetoric from Russia on Ukraine along with softening sentiment and positioning at the Fed meeting contributed to the euro’s losses on Wednesday, with the common currency down as much as 0.9% against the greenback.

“If the euro falls out of bed, the Fed may not want it to get worse,” said John Weil, chief global strategist at Nikko Asset Management Co. in Tokyo. “It would be more of a global financial stability concept than anything to do with the dual mandate.”

(Updates with Euro movements and CDX spread data)

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