Believe it or not, investors do sometimes think about things that are not directly related to US interest rate policy.
Of course, the debate over what the Federal Reserve does next matters. It is unquestionably the biggest issue of the moment. This week it dominated otherwise sleepy summertime market conditions yet again, thanks to data showing a modest slowdown in inflation.
The annual rate dropped to 8.5 per cent in July, the Bureau of Labor Statistics said on Wednesday, down from 9.1 per cent in the previous month, firing up expectations that the Fed might be convinced to damp down interest rate rises. This so-called pivot has been on again and off again more times in the past month than I care to remember. It has the shelf life of a Tory leadership candidate’s core policy agenda. But now, to some degree at least, it is back on, supporting stocks.
To be sure, this could be the start of something big. Maybe inflation really is going to trend lower from here. Maybe it was transitory after all, if you can torture the definition of transitory hard enough. But if you think the Fed is going to take its foot off the gas with headline inflation running at 8.5 per cent, against its target of 2 per cent, I have a bridge to sell you.
“If we had zero per cent inflation month on month every month (which would be incredibly dovish) until the end of the year, we would still have inflation above 6 per cent in December,” note analysts at Mirabaud. “The momentum may be decelerating but . . . 8.5 per cent is still too high.”
Mary Daly, president of the San Francisco branch of the Fed, rammed that point home in an interview with the FT. “We don’t want to declare victory on inflation coming down,” she said. “We’re not near done yet.” Will that put a stop to this debate? No chance.
One problem is that this noisy exchange, important as it is, drowns out everything else. Meanwhile, a lot of bond investors have a different matter on their minds: defaults. These have been something of a rarity while central banks have flooded the system with free money, but failures by governments and companies to pay back what they owe are expected to become much more frequent.
In government debt this could get very tricky, particularly for those countries that have borrowed in dollars that are now much more expensive to pay back. Leland Goss, general counsel at the International Capital Markets Association, pointed out in a recent report that even in the decade before Covid struck, borrowing in emerging markets grew from $3.3tn, or about a quarter of economic output, to $5.6tn, almost a third.
Strain is beginning to show in Sri Lanka, which has already admitted it cannot pay investors back, but also in bonds issued by Kenya, Egypt and elsewhere. The prospect of a “possibly systemic sovereign debt crisis” is real, Goss said.
The nightmare scenario here is that lots of defaults come all at once. “Creditors with exposures to not one or a few but many sovereign borrowers could face large aggregate exposures,” Goss said. “Creditors could themselves experience financial difficulties and potential systemic implications, particularly if they are financial institutions.”
That is indeed a potentially pressing issue for fund managers with concentrated exposures to emerging markets, and if Goss is right, it’s worth the rest of us watching closely too. There’s “no magic bullet” to sort this out, he said, but “a pre-emptive, co-ordinated multilateral debt restructuring” could at least bring some order to the process.
Corporate debt investors are also braced for a more difficult environment. “I’m not a doomsayer at all,” says Pierre Verle, head of credit at European asset manager Carmignac. “I don’t expect an uncontrollable wave of defaults. But we’re re-entering a world where capital has a cost.”
The ICE BofA euro high yield index shows that very clearly. At the start of this year, yields — a proxy for borrowing costs — hovered at a little under 3 per cent. Remember this is for risky high-yield borrowers, not gold-plated safe issuers. Now it has swept as high as 6 per cent, having breached 7 per cent in July when the frenzy over central bank rate rises hit its peak.
Rating agency Fitch reckons that with economic risks intensifying and benchmark interest rates rising, high-yield default rates could double in the US this year from last, reaching 1 per cent, and also double in Europe to 1.5 per cent.
Verle thinks overall it could be much higher. “Over the next five years, I think you see a 4 per cent default rate a year, so in a five-year span, one in five will default in high yield. It’s a lot.” Levels like that would take us back to what we saw in 2020 — not a vintage year.
That does not alarm Verle — his previous roles in distressed debt markets have toughened him up for this experience. “I come from a background in distressed debt so my expectations are very, very low,” he says. But others are likely to find this more bracing.
The spinning Fed pivot debate sucks in a lot of intellectual energy in markets, and for good reason. But take your eye off these other issues at your peril.