Fed’s Decision Creates Challenges for Credit Markets
TOM BUTCHER: In light of the recent Fed decision, how should investors think about risk?
FRAN RODILOSSO: There are all sorts of risks investors need to think about for financial markets in general in the fourth quarter, but specific to the Fed, I think what's coming up now is credibility risk. The Fed had an opportunity to move in September when markets returned from summer break, when there was some expectation that a September hike might happen. By postponing the hike for now, the Fed may be justified in reacting to signs of greater deflationary pressures, but the Fed may also be showing some weakness in its longer term strategy. They may also be boxing themselves in. With the October Fed meeting there is no press conference and no revised estimates, so it would be a difficult time for to hike rates. The December Fed meeting is on December 16. Almost by definition, that will be a market that is much less ready to absorb news like that in terms of liquidity, so the Fed may be boxing themselves into having to wait until 2016.
If the market perceives that, the Fed may start losing credibility in terms of its ability to engineer an elegant departure from the zero interest rate policy. This will play out in fixed income markets with duration versus credit risk. The Fed may start hiking, but there's still some steepness to the Treasury curve and 10-year yields were still well over 2% in the week after the Fed did not move. While that's historically low, it’s still much higher than yields in Germany, which were about 150 basis points lower. They were above yields even in Italy and the U.K., countries with higher credit risk or countries that have already been hiking.
Duration risk with regard to where the Fed goes from here probably shouldn't be at the forefront of investors' minds. I think investors have justifiably been more cautious on credit, particularly lower-rated credit, in recent months. During parts of 2014 and most of 2015, we've seen declining trends in credit quality, both at home and abroad in corporate credit.
We are near the end of one type of credit cycle. We’re in a low interest rate environment and this credit cycle has enabled borrowers to push out maturity significantly, both investment grade and high-yield borrowers. In the U.S., Europe, and emerging markets, they've been able to refinance at lower rates, lowering their overall cost of capital. We should see an uptick in default rates; we already have this year. We've seen declining trends in ratings as well. However, at the same time we've seen credit spreads widen out.
BUTCHER: What should investors be concerned about going into Q4 of this year?
RODILOSSO: As recent market volatility has displayed, investors feel they have a lot to be concerned about going into the fourth quarter, and there are some areas of concern that remain. I think investors need to keep their concerns in perspective. China is an economy going through an adjustment. The government is trying to engineer a transition from a fixed investment-based economy all about production to a consumer-based economy. That's going to be a very slow and difficult process.
There will be pockets of trouble in China. I think investors need to remember to look at China from a holistic point of view, but also understand that certain sectors may experience very difficult times, but it does not mean that the entire economy is about to unravel. The transition, if it's pulled off successfully, should be a positive one in the long run. Also remember, the People's Bank of China still has flexibility. It still has some room in rate policy; it still has very high international reserves, though it has been spending the reserves to defend the currency after recent policy moves. China will be a focus, but it does require some perspective.
Commodity prices tie into China, growth, and credit markets. It’s the energy sector and material sector that have pulled out spreads in both U.S. high yield and international high-yield markets, as well as investment grade markets. Investors will need to be wary.
In my opinion, it means the biggest risk for the fourth quarter outside of those markets is the volatility that is caused by the Fed not moving yet, by the anticipation of higher rates, and by what the impact might be. This sort of volatility may build on itself and the market may begin to lose faith in the Fed's ability to engineer an elegant departure from its zero interest rate policy, which has been in place since December 2008, i.e., for nearly seven years. The U.S. economy is on a much different and much healthier footing than it was in December 2008. When you look at it from that perspective, a 25 basis point move doesn't seem like a whole lot.
BUTCHER: Fran, thank you very much.
RODILOSSO: Thank you, Tom.
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