August 2022 Credit Market Update:
Fed Pivot? Not This Time.
The July and early August question of whether the markets were recovering or if it was a bear market rally was answered, with the bears remaining firmly in charge. The catalyst was Chairman Powell’s recent remarks, where he made clear that the Fed is committed to getting inflation under control.
The rally appeared to be the result of market participants’ overly-optimistic view that the Fed would potentially begin to reduce the number and/or shrink the size of rate increases, with a likelihood of lowering rates in 2023. The history of the “pivot” is the Fed’s backing off rate increases and quantitative tightening during the recovery from the global financial crisis, in response to a market overcorrection.
Positive economic data, including a blockbuster jobs report released in early August, may have pushed the Fed to be very clear on its potential future decisions regarding interest rates. The Fed is also intent on shedding its immense balance sheet as part of normalizing monetary policy.
In his remarks, Powell focused on the inflation of the 1970s, and the need to act decisively on rates. His words were “forceful and rapid,” and he acknowledged the economic pain this would cause. Powell’s view is the Fed needs to act decisively to bring inflation down quickly, or consumer expectations for higher inflation will become entrenched, and inflation will become intransigent.
This could not be more different from the “transitory” language we saw at this time last year, as inflation declined over the summer, and then bounced back up in the fall and winter. The Fed’s citing of the 1970s is a historical underpinning to the Fed being cautious about curbing the tightening of monetary policy too soon. It could also be interpreted as the Fed taking responsibility for its dilatory approach to rates until May of this year.
The Bureau of Labor Statistics reported on September 13th that the Consumer Price Index (CPI) increased 0.1% for the month of August, seasonally adjusted. CPI rose 8.3% over the last 12 months, not seasonally adjusted. This is a slight decline from the 8.5% increase in July.
How Did the Credit Markets React?
Treasury yields rose, almost hitting the June year-to-date peak. After a mostly positive July, most major credit sectors declined in August. The Bloomberg Barclays U.S. Aggregate turned in its sixth month of negative performance, retracing all the gains from July, which was its best month year-to-date.
A Closer Look: What Does the Fed’s Crystal Ball Say?
The Fed doesn’t have a crystal ball. Its version of a Palantir is called the “Beige Book.” It’s published eight times per year, and aggregates anecdotal information on current economic conditions in each of the twelve Fed Districts. It also provides information on the outlook going forward. The current report is from July through the end of August.
- Overall economic activity focused on the shift in consumer spending: “Households continued to trade down and to shift spending away from discretionary goods and toward food and other essential items.” The outlook for future economic growth “remained generally weak, with contacts noting expectations for further softening of demand over the next six to twelve months.”
- Overall labor market conditions highlighted that wages continued to grow, “although reports of a slower pace of increase and moderating salary expectations were widespread.” The outlook for wages is a little more choppy, with “expectations for the pace of wage growth varied across industries and Districts.”
- Price levels remained highly elevated, and “Most contacts expected price pressures to persist at least through the end of the year.”
Performance Among Credit Indices
Chart Spotlight: Private Credit Continues to SEE Demand
Institutional investors continue to lead the way in increasing allocations to private credit, with senior middle market debt, which is typically floating rate, leading the way.
Top Picks for Future Private Credit Investment (%)