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.
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.