Riskiest Corporate Bonds Show Federal Reserve Has Room for Hikes

(Bloomberg) -- January saw a lot of equity-market volatility. But February may allow markets to calm. If you look at yields for the lower-rated high-yield bonds, there is little reason for concern. Credit may take on greater importance as the Federal Reserve assesses financial conditions, and that makes the next three Fed rate hikes a lock.

Yields for Caa bonds, a canary in the coal-mine for credit conditions, bottomed in July and have been rising since the Fed began normalizing policy. But the recent rise is dwarfed by twin peaks of stress in high yield over the last seven years. In fact, Caa yields today are actually lower than at any time before late 2020 except brief periods in 2013 and 2014 during the shale boom.

So, despite the 5.3% tumble in the S&P 500 in January and concerns about over-tightening, the Fed has room to run before credit conditions bite. Moreover, after the last FOMC meeting, Chairman Jerome Powell told reporters that the Fed isn't targeting equities or even Treasury duration spreads in judging financial conditions. Instead, it looks at a broad array of markers to determine if it is over-tightening.

The upshot is that one could argue that credit conditions play a more important role in the Fed's thinking than curve inversion or equity selloffs. For example, when you look back to the Powell Pivot in 2019, you can see Caa spreads gapping up right before the pivot. When yields peaked in late December 2018, they did so at levels 5% higher than they are today.

Not only is high-yield credit stress nowhere near levels seen during the shale oil bust or the pandemic panic, it is even considerably lower than late 2018. The Fed will see that as a green light for front-loading rate hikes and raising at the next three FOMC meetings. Since this is largely priced in, the liquidity musical chairs that started with equities last month can take a breather until the Fed signals a step-up in normalizing.

This was a post on Bloomberg's Markets Live blog. The observations are those of the blogger and not intended as investment advice. For more markets analysis, go to MLIV.