Evening Brief – 05.04.23

At about 3.40%, the 10-year US Treasury note is now well below its 52-week high of 4.33%, which was hit in October 2022. The drop in yield, even as the Fed has continued to raise short-term rates, suggests investors are preparing for a recession in the near term as well as ongoing anxiety about the financial system’s stability in light of recent bank failures.

In fact, the Fed’s preferred recession rate-spread indicator – the 3-month/18-month forward – is now flashing red, implying a 94% probability of a recession within the next year.

That said, market participants seem too complacent when it comes to risk assets given this cocktail of higher interest rates, quantitative tightening (which probably has more of an impact on risk assets than rate hikes or cuts) and credit contraction. Under these conditions, one can expect higher default rates on lower quality fixed income securities, perhaps by the end of the year.

Investors should be going up in quality in bond portfolios. When bonds are defaulting, or spreads are widening on the lower tiers of credit it makes for a very difficult bullish case to own equities. Risk needs to be very carefully managed right now.

Fed Chair Jerome Powell seems to be running a “separation policy”, where the central bank can focus on monetary policy on one hand and regulatory policy on the other hand. Given recent comments from former Boston Fed president Eric Rosengren and former Dallas Fed president Robert Kaplan, they likely have a problem with this approach. Potentially further raising interest rates or simply keeping them high while the banking system continues to have problems can cause major headaches for the financial markets.

The quarter-point rate hike on Wednesday did not help the banking system. It made some of the marks (Treasury holdings by many of the regional banks) even more underwater. The likelihood of a credit crunch just increased.