Cat on a Hot Tin Roof – Some Explanations and Information

A cat on a hot tin roof is the appropriate image for how the financial markets and economies feel and are reacting at the moment. An avalanche of commentaries and volumes of data are pouring into and being poured over by a myrid of individuals, specialists, talking heads, and governmental bodies. There is no shortage of information, opinion, comment, commentary, noise and confusion. I have found a couple of articles over the past 2 weeks I think may be interesting and helpful. I am including them in their entirety.

Some observations. Quoting from the first line of the Bloomberg article, “The world’s most powerful central bank is about to find out how far it can squeeze financial markets before something breaks.” That sums up exactly what is happening. That is the 900 lbs. gorilla in the room. If or when it breaks, that is recession. The 2^nd article from the Spokane Review (originally from Bankrate.com) is a pretty good discussion on how rising interest rates may impact various financial instruments. Remember, don’t focus on the hype language. Look for the solid information. Good luck. Hang in there and don’t panic.

https://www.bloomberg.com/graphics/2022-world-economy-wall-street-market-worries/

Bloomberg

Everything That Could Go Wrong in Markets as Free-Money Era Ends

By Jack Pitcher, Alexandra Harris, and Alex McIntyre

May 9, 2022, 6:00 AM MDT

The world’s most powerful central bank is about to find out how far it can squeeze financial markets before something breaks. Struggling to tamp down the most pervasive inflation in decades, the Federal Reserve delivered its biggest interest-rate increase since 2000 last week while outlining a plan to begin unwinding trillions of dollars in asset purchases that have kept world markets brimming with cash since the 2020 crash. Its peers will soon follow suit. Bloomberg Economics has estimated that policy makers in the Group of Seven countries from the European Central Bank to the Bank of Canada will shrink balance sheets by about $410 billion combined in the remainder of 2022.

Yet it all comes at one of the most precarious times in recent memory for the global economy. Russia’s war in Ukraine, and the bevy of sanctions that followed, have upended business. Supply chains that were disrupted by the pandemic have grown even tighter, causing chaos for companies lashed by soaring prices for everything from labor to commodities. The worry now is whether central banks can accomplish the high-wire act of weaning Wall Street off unprecedented stimulus, without disrupting the flow of capital and tipping economies into recession.

Bloomberg News canvassed traders, money managers and analysts on their top market indicators to track corporate distress, liquidity shocks and cracks in the financial plumbing. We then analyzed decades of price history to identify the systemic turning points — when central bankers on a hawkish mission risk crashing the real economy.

While there’s little sign of widespread stress yet, some barometers of cross-asset health are moving closer to the danger zone. All that suggests investors are in for a bumpy ride as the Fed drains its unprecedented liquidity measures.

Here are four indicators keeping Wall Street worrywarts on edge.

1. An Upside-Down Bond Market

Like it or not, the U.S. Treasury yield curve remains the top dog economic forecaster on Wall Street — even if the Fed’s bond-buying spree in the pandemic has distorted its message. In normal times, when the business cycle is in good health, the interest rate on debt maturing in, say, 10 years, will be higher than that on shorter-term securities as investors demand more compensation for the risk that inflation down the road will erode returns. If the opposite happens, meaning short-term rates are higher than the longer term, the foreboding dynamic is known as an inversion — signaling a bet that the central bank will eventually have to cut rates in order to salvage growth.

While not every inversion in the yield curve has led to a downturn, prolonged distortions have become eerily accurate, especially when two of the most widely followed curves become inverted at the same time, data compiled by Bloomberg show. Since the beginning of the 1990s, whenever yields on both 3-month Treasury bills and two-year notes have risen above the rate on 10-year bonds, a recession has followed almost without fail within the next six to 18 months. It's a simplified measure — the most recent double inversion preceded a pandemic that no one saw coming — but big moves in yield curves have kept Wall Street on edge recently.

In late March and the start of April, the gap between two- and 10-year yields briefly inverted before normalizing, reflecting market angst that the Fed’s mission to aggressively tighten policy risks sparking a recession by ramping up the cost of money and thereby constraining consumer spending as well as business activity. At the same time, the spread between the three-month Treasury bill and the 10-year yield has been heading in the opposite direction, suggesting a still-healthy outlook for U.S. investment and consumption that gives the central bank room to make good on its policy-tightening plan.

For now, yield-curve worriers are easy to find as the end of the easy-money era rocks global markets. Already this year, the Nasdaq 100 index of technology shares has had the worst start in decades, speculative stock strategies have lost billions and cross-asset volatility has spiked all over the world.

PGIM Chief Executive Officer David Hunt warned last week that signals in the bond market suggest a significant risk of a recession in 2024, while Citadel’s Ken Griffin said the outlook is the most uncertain since the global financial crisis.

2. Disruption to the Flow of Credit

U.S. companies have lost their ability to borrow money at ultra-cheap rates, a direct function of the Fed’s mission to cool the red-hot business cycle that’s stoked inflation for everything, everywhere all at once.

But when borrowing costs surge too far, too fast, the flow of corporate credit can become disrupted or even blocked entirely. In extreme instances, healthy companies can lose access to funding, wreaking economic havoc. This happened most recently during the onset of the pandemic, which forced the Fed to take unprecedented action to keep corporate America afloat.

The most widely followed credit gauge is the additional yield over Treasury bonds that investors demand to hold debt from the largest and strongest U.S. corporations. Currently, the spread on a Bloomberg index of U.S. investment-grade bonds has risen to 1.35 percentage points, from as low as 0.8 percentage point in June 2021, signaling higher borrowing costs that still sit below a key threshold for stress.

When the spread rises above 1.5 percentage points, it’s a warning sign that credit markets could seize up, making borrowing a lot harder, according to analysts and investors informally polled by Bloomberg. The metric has proved a reliable red flag in the past after crossing 2 percentage points in the volatile years after the global financial crisis and during the pandemic fallout.

To illustrate how the flow of credit across the entire U.S. economy can constrict, Bloomberg examined commercial and industrial loan data from all commercial banks, published monthly by the Federal Reserve.

The analysis, dating back to 1989, shows that when investment-grade credit spreads approach and exceed 2 percentage points, a threshold that’s been crossed just six times over that period, a contraction in loan growth almost always follows.

In January 2008, for example, borrowing costs for investment-grade companies soared to more than 2 percentage points for the first time in more than five years. Risk premiums remained above that level for nearly two years, and a prolonged slowdown in commercial and industrial loan volumes came next. Loan volumes fell for two years beginning in November 2008, causing historic damage to the world economy.

More recently, credit spreads spiked to over 3.5 percentage points in the March 2020 selloff. Yet some of the easiest borrowing conditions on record took hold in the following year as the Fed pumped liquidity into the financial system and even offered to buy corporate bonds directly.

Now premiums are back on the rise and company debt is becoming volatile. Investors and companies alike will be watching whether borrowing costs spike into risky territory that would disrupt the flow of credit once more.

3. The Junk Penalty

Borrowers with weak balance sheets were given a reprieve after the Fed and other central banks rode to the rescue in the dark days of the pandemic. For the better part of two years, credit was dirt cheap and defaults became virtually non-existent. But the liquidity party is coming to a rapid end as interest rates rise — with new speculative-rated debt offerings this year falling to the lowest volume since 2009.

A recent bond sale from Carvana Co., for example, initially struggled to attract investors, and the used-car company ended up paying a whopping 10.25% yield while buyers demanded a clause intended to help shield them from losses if the company were to head to bankruptcy court. Similar cases abound.

A measure investors are watching closely is the extra risk premium that bond buyers demand to own debt from the lowest-rated companies compared to investment-grade peers. Call it the junk-bond penalty. When this premium goes up, it makes borrowing more costly and less accessible to issuers who need the funding the most, especially those who have poor credit ratings due to weak cash flows or high debt loads compared to their earnings.

If firms that have limited money on reserve and debt coming due in the near future lose access to primary markets, that makes defaults and bankruptcies more likely — bad news for growth-minded policy makers at the White House.

For most of the post-pandemic era, junk-rated companies across the globe paid little more to borrow than some of the biggest corporations — an average of just 2.4 percentage points more during 2021, a year that saw some of the easiest credit conditions ever, according to data compiled by Bloomberg. That made corporate failures exceptionally rare. But the tide is starting to turn. The junk penalty climbed above 3 percentage points last week. While that’s below the historical average of about 4 percentage points, the fast pace of liquidity tightening could soon cause trouble for the most vulnerable of companies. Since 2000, when the junk penalty has climbed above 5 percentage points and held above that level for an extended period, defaults have almost always risen above the historic norm, data compiled by Bloomberg show.

4. Short–term money markets crack

The Fed’s massive pandemic stimulus program caused excess liquidity in the financial system to balloon, with banks flush with record cash in the form of reserves. Now, as the monetary authority begins to pare a $9 trillion balance sheet, a process known as quantitative tightening, Wall Street is on high alert for any resulting logjams in the financial plumbing.

When the Fed starts to shrink asset holdings — by simply not replacing maturing securities — there will be an increase in the number of Treasuries and mortgage bonds in search of a home in the private sector. And the amount of reserves held in the banking system will fall by design.

No one knows how any of this will ultimately play out. But the last time the central bank embarked on quantitative tightening, bad things eventually happened in late 2019. Banks saw their reserves fall sharply — fueling a disruptive spike in interest rates on so-called repurchase agreements, a keystone of short-term funding markets. That caused liquidity headaches all around and forced the central bank to intervene in the funding markets.

The Fed has since implemented additional tools to help reduce these liquidity risks. But all bets are off. Some two and half years ago, total reserves held by depository institutions at the Fed slid to around $1.4 trillion. That was enough to cause liquidity issues in overnight lending, even though banks at the time considered $700 billion as the lowest threshold for comfort.

This time round, Barclays Plc estimates the tipping point at some $2 trillion versus $3.3 trillion currently. All this is guesswork with few historic precedents, so the reserve level will be a key focus for risk watchers well before it hits this point.

All in, traders around the world are bracing for a disruptive tightening in financial conditions on multiple fronts, from bonds and credit to money markets, as the Fed spoonfeeds markets with liquidity no longer.

“We have never been able to reduce inflation by more than 2 percentage points in the U.S. historically without inducing recession,” said Guggenheim Partners Chief Investment Officer Scott Minerd at the Milken Institute Global Conference in Los Angeles. “I think that it's going to be really hard for the Fed to maneuver into a soft landing.”

https://www.spokesman.com/stories/2022/may/09/biggest-winners-and-losers-from-the-feds-interest-/

The Spokesman Review - Spokane, Washington

Biggest winners and losers from the Fed's interest rate hike

Updated: Mon, May 9, 2022

Spokane, Washington

James Royal    Bankrate.com (TNS)

Last week, the Federal Reserve announced that it’s raising interest rates by half a percentage point, bumping the federal funds rate to a target range of 0.75 to 1.00 percent. The move follows an increase of 0.25 percent in March, as the Fed continues reducing liquidity to the financial markets to help tamp down soaring inflation.

The central bank also announced that it was further reducing stimulus to financial markets by letting its holdings of bonds decline over time. The Fed will work its way up to letting about $95 billion in bonds roll off its balance sheet every month, reducing liquidity by about $1 trillion per year.

The Fed’s move comes as inflation rages in the U.S. economy at the highest annual rate in some 40 years, hitting 8.5 percent in March. With the Fed hitting the brakes on an overheated economy, the main question for many market watchers is how fast Federal Reserve Chairman Jerome Powell & Co. will continue to raise rates.

“The Federal Reserve is behind the curve on inflation and has a lot of catching up to do,” says Greg McBride, CFA, Bankrate chief financial analyst. “This means rate hikes at successive meetings for the first time in 16 years, and for the first time in 22 years, a larger half-point hike.”

At about 3 percent, the 10-year Treasury bond is now at its highest level since late 2018, as markets price in the expectation of sustained inflation and rising rates. After some ups and downs in 2021, the benchmark bond has soared since December 2021 and especially since the start of March, when it sat at just 1.65 percent.

As the Fed embarks on what appears to be a longer period of raising rates, here are the winners and losers from its latest decision.

1. Mortgages

While the federal funds rate doesn’t really impact mortgage rates, which depend largely on the 10-year Treasury yield, they’re often moving the same way for similar reasons. With the 10-year Treasury yield zooming higher in recent months, as the market prices in expectations of the Fed raising rates, mortgage rates have risen alongside them.

“Mortgage rates have bounded higher by 2 full percentage points since the end of 2021, one of the largest and fastest run-ups in history,” says McBride. “Mortgage rates move well in advance of Fed action and the outlook for inflation and the economy will be the key determinants of what we see with mortgage rates in the months ahead. Until we see signs inflation has peaked, the risk is definitely to the upside.”

The run-up in rates – following the rapid rise in housing prices over the past couple years – has created a double whammy for potential homebuyers. Home prices are more expensive and the financing is pricier, resulting in a slowdown in the housing market.

So would-be homebuyers are worse off by the rise in rates.

2. Home equity

The cost of a home equity line of credit (HELOC) will be ratcheting higher, since HELOCs adjust relatively quickly to changes in the federal funds rate. HELOCs are typically linked to the prime rate, the interest rate that banks charge their best customers.

Those with outstanding balances on their HELOC will see rates tick up, though interest expenses may continue to be low historically. A low rate is also beneficial for those looking to take out a HELOC, and it can be a good time to comparison-shop for the best rate.

But with rates moving higher, even a little bit, and the expectation that they’ll move higher still as the year progresses, those with outstanding HELOC balances should expect to see their payments continue to rise in the near term.

3. Credit cards

Many variable-rate credit cards change the rate they charge customers based on the prime rate, which is closely related to the federal funds rate. The Fed’s decision means that interest on variable-rate cards will move higher now.

“Credit card rates will march higher in step with the Federal Reserve, and often follow within one or two statement cycles,” says McBride. “Pay down credit card debt now because it will only get more expensive and you don’t want that debt hanging over your head, should the economy topple into recession.”

If you have an outstanding balance on your cards, then you’re going to get hit with higher costs. With rates projected to rise for a while, it could also be a welcome opportunity to shop for a new credit card with a more competitive rate.

Low rates on credit cards are largely a non-issue if you’re not running a balance.

4. Savings accounts and CDs

Rising interest rates mean that banks will offer rising returns on their savings and money market accounts, but will likely adjust their yields at a measured pace.

Account holders who recently locked in CD rates will retain those yields for the term of the CD, unless they’re willing to pay a penalty to break it.

Those with savings accounts may look forward to rising rates, but it’s off a low base, as most banks quickly ratcheted rates to near zero following the Fed’s emergency cuts in March 2020.

“Yields on certificates of deposit have started to pick up and we’ll see the same in savings yields, although with a bit of a lag,” says McBride. “The outlook for the next year or so is much better than what savers have endured over the past three years, where rates fell and then inflation took off.”

“It will take a while, but as rate hikes continue, the returns savers get will rise and inflation will hopefully decline,” he says.

Savers looking to maximize their earnings from interest should turn to online banks, where rates are typically much better than those offered by traditional banks.

5. Stock and cryptocurrency investors

A huge boon for the stock market has been the Fed’s willingness to keep rates at near zero for an extended period of time. Low rates have been beneficial for stocks, making them look like a more attractive investment in comparison to rates on bonds and fixed income investments such as CDs. But that’s changing.

In the last few months, investors have been pricing in the potential for rate increases, with the S&P 500 starting 2022 in a deep slump.

“The market went up with little hesitation while the Federal Reserve was pumping stimulus into the economy, but now that they’re removing that stimulus, market volatility has returned,” says McBride. “Particularly susceptible have been the high-octane growth stocks that were the primary beneficiaries of low interest rates, with investors now questioning what value to put on those stocks in a higher interest-rate environment.”

Cryptocurrencies have also been feeling the brunt since November, when the Fed more clearly telegraphed its intentions to reduce liquidity in the financial system. Bitcoin, Ethereum and other major cryptos are well off their 52-week highs and have shown a solid downtrend over the last few months, as they priced in reduced stimulus and the potential for higher interest rates.

The Fed’s reduction in its own bond portfolio should further decrease support for stocks and crypto.

6. The U.S. federal government

With the national debt above $30 trillion, rising rates will raise the costs of the federal government as it rolls over debt and borrows new money. Of course, the government has benefited for decades from a secular decline in interest rates. While rates might rise cyclically during an economic boom, they’ve been moving steadily lower long term.

For now, the interest rates on debt remain at historically attractive levels, with 10-year and 30-year Treasurys running well below inflation. As long as inflation remains higher than interest rates, the government is slowly taking advantage of inflation, paying down prior debts with today’s less valuable dollars. That’s an attractive prospect for the government, of course, but not for those who buy its debt.

Bottom line

Inflation has been running hot over much of the last year, and the Fed is raising interest rates to combat it. But rates still do remain low by historical standards, at least for now, so it makes sense to think about how to take advantage, for example, by being more discriminating when it comes to shopping for rates on your savings accounts or CDs.

(Visit Bankrate online at bankrate.com.)

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