Looking for Cracks

Looking for Cracks

“If rates continue to rise the way they’ve been rising, there will be a financial accident.  Something will break and that will get the Fed moving in the other direction,” said David Lebovitz of JP Morgan on October 2, 2023.

There are usually cracks in the system that show up before something breaks.  Our team is monitoring the following items; they can serve as a barometer pointing to when and if a “financial accident” might occur.

Bond Spreads.  An early warning indicator that something is about to break is often first noticed in the spreads between high quality bonds and low quality (junk) bonds.  During periods of uncertainty these spreads can widen causing losses to junk bond holders as the price of the bonds drop.  In periods marked by stability and calm, the difference between the yield in junk bonds and treasury bonds is often somewhere between 3.5%-4%.  This means that investors receive a higher yield of about 3.5%-4% on junk bonds in return for taking on more risk.  After September 11, 2001, the spread jumped to over 10%.  During the Great Financial Crisis, it spiked to over 20% and during the outbreak of Covid, in 2020, the spread jumped to almost 11%.  If you are holding a junk bond when spreads widen this dramatically, you could suffer tremendous losses should you need to sell the bond before maturity.  The current spread, as of September 30, 2023, was 4.03%.  At this time, the bond market is not broken and not pointing to an imminent recession or heightened economic uncertainty. (1)

Property.  Rising interest rates often strain housing and commercial real estate prices.  This is especially true in Europe and China, where long-term mortgages aren’t used as much in the purchase of real estate.  According to Reuters, a string of German developers have been tipped into insolvency, London’s office market is in a “rental recession” as vacancies hit 30-year highs and US banks revealed losses from property loans in the first half of the year and warned of more to come.  In China, the Evergrande Group has over $300 billion in total liabilities, is at the center of an unprecedented property sector liquidation crisis.  The commercial property market seems to be breaking.  (2)

Economic Growth.  The Wall Street Journal wrote a thought-provoking article about the economy and how it continues to defy expectations.  Much of their analysis goes back to Covid-Era buffers and government spending that have helped prop up the economy so far this year.  Individuals and corporations have been flush with cash and pent up demand, especially on the consumer side, have thus far not been impacted by rising rates.  Also, the consumer’s household debt-service payments as a share of disposable income is well below the 50-year average.  Consumers have a lot of debt, but much of it (especially mortgages) were locked in at rock-bottom rates.  According to the Federal Reserve, the average consumer uses about 9.6% of their income to service debt, while the average over the past twenty years was closer to 11%.  Economists are divided over the outlook.  Some believe inflation is now mostly under control and expect the Fed will cut rates next year, enabling a soft landing.  Others worry the Fed has done too much or will need to lift rates even more to crush demand to get inflation under control. Economic growth does not appear to be breaking, but the irony is that the longer the economy is strong the more likely the Fed will need to keep rates higher for longer thereby increasing the odds of something breaking.

Geopolitical Events. The impact of the Hamas-Israel war may take time to become clear.  “We expect short-term volatility in the stock market and oil market as investors digest the heightened tensions in the Middle East.” said James Demmert, chief investment officer at Main Street Research. However, it could become more severe if the conflict lasts or spreads to the rest of the Middle East, especially Iran, which is a major oil producer.

Washington. The House of Representatives is without a leader since the recent ousting of Kevin McCarthy from his position as speaker. The speaker is one of the key leaders of the government who would normally be a crucial player at a time of global uncertainty. Further, the speaker is necessary for negotiating a budget deal to avoid a government shutdown where the deadline was kicked down the road to mid-November.

In our view, if rates stay elevated well into 2024 the odds of something “breaking” increase.  This would most likely result in a reduction in interest rates, which would benefit high-quality bonds as interest rates fall.  Times of uncertainty is when it is especially important to have a financial professional monitoring the markets. We maintain our commitment to doing what is best for our clients and will make recommendations and adjustments as necessary.

Sources:  (1) St Louis Federal Reserve FRED ICE BofA US High Yield Index Option-adjusted Spread.  (2) Reuters.com What could break under higher-for-longer interest rates? 9/29/23  (3) Resilient US Economy Defies Expectations 09/02/23