Financial markets have started the year facing a host of challenges, including the prospect of a stand-off over the debt ceiling in a divided Congress and the possibility of a recession later this year.
Yields are rising to compensate for greater risk, and that increases the cost of capital for businesses.
At the same time, businesses are contending with higher costs associated with the shift from low-cost production in China and rising interest rates. Now, with the war in Ukraine still raging and a global economic contraction looming, uncertainty has surpassed the high level of the trade-war era, before the pandemic.
All of this risk is showing up in global financial markets, including the U.S. bond market. Yields are rising to compensate for this greater risk, which increases the cost of capital for U.S. businesses.
Rising yields…
The yield on a 10-year Treasury bond has increased by more than 200 basis points, rising from 1.5% at the end of 2021 to 3.6% in the first week of January. The average yield of investment-grade (Baa) corporate bonds rose by 240 basis points, from 3.4% to 5.7%.
With inflation expected to remain well above the Federal Reserve’s 2% target for the next two years, that implies that real, or inflation-adjusted, interest rates will remain negative or at low levels, which might allow businesses to continue investing in productivity.
… lead to rising spreads in corporate bonds…
With interest rates moving away from the zero bound, we can expect a wider range of interest rates to reflect the increased risk. This is evident in the interest rate spread between the guaranteed yield of Treasury bonds and the rates on corporate bonds, which carry the potential of default.
…and the money markets as well
Another measure of risk is found in the money markets, through the interest-rate spread between unsecured floating rate agreements and the virtually risk-free overnight indexed swap rate security based on the federal funds rate.
The FRA/OIS spread has been increasing as near-term expectations for risk in the money market have risen. That spread could increase if the debt ceiling debate were to escalate.
The bond market responded to the Fed’s hikes…
Because shorter-term U.S. bond yields reflect expectations for the federal funds rate, money market rates and shorter-term bond yields have moved higher than longer-term rates.
This has resulted in a so-called inverted yield curve, as opposed to the more normal upward sloping yield curve evident at the end of 2021 before inflation and the Russia-Ukraine war had its effect.
…while factoring in the risk of recession
With the Fed trying to reduce demand and slow the economy, the bond market has been factoring in the probability of lower demand for capital in the coming months. This is consistent with the period before the past three recessions, when the spread between long-term and short-term interest rates turned negative.
The takeaway
Financial conditions remain tight to start the year, though they had improved late last year as equity markets responded to slowing inflation. If inflation were to continue to retreat, the equity market would expect the Fed to suspend or slow its rate increases, which would allow for a softer landing and a faster return to normalcy. The bond and money markets continue to factor in more risk of a recession.
