Evening Brief – 05.11.23

The Federal Reserve’s withdrawal of duration risk will cause the private non-bank sector to be exposed to higher rates and credit spreads vulnerable to aggressive widening.

The Fed has been preventing rising rates from having a significant negative impact on the economy. But now it is stepping back and letting the rest of the economy deal with the consequences after what may have been its final rate hike of the cycle, potentially exacerbating a recession that may already be under way.

The primary adjustment will be wider credit spreads as increasing interest rate risk puts more strain on the balance sheets of the non-bank private sector.

Quantitative tightening predicted that banks would carry a large portion of the load as it developed, increasing their ownership of US Treasurys, mortgage-backed securities and other debt instruments.

Instead, they have also been gradually reducing the term risk. The result is that the non-bank private sector, corporations and households, are absorbing an increasing amount of duration, which indicates that the previously muted impact of rate increases is set to become more pronounced.

Banks appear destined to continue selling their bonds because the Fed has shown no indication that it plans to reduce QT. The availability of bank loans to the non-bank sector is also rapidly decreasing.

When observing the US yield curve, it should not be shocking that smaller banks are in trouble. The degree of inversion emphasizes the pressure on smaller banks’ margins because they are both long-term lenders and short-term borrowers.

Typically, yield-curve flattening is followed by widening credit spreads. But while spreads have only slightly widened, we have witnessed one of the worst curve inversions in over four decades, providing unambiguous evidence that the Fed has been protecting the economy from the majority of rate hikes.