July 2022 Credit Market Update:
Tug of War, Fed Edition
The Fed raised the short-term interest rate by 75 basis points at the July FOMC meeting, as expected. In his comments, Fed Chairman Powell indicated that previous interest rate cuts may have an impact on the economy that is “in the pipeline” but not yet reflected in the data. This was initially interpreted by some market participants to mean that the Fed may slow down rate increases and even consider cuts later in 2023.
The annualized rate of GDP was -0.9% in the second quarter, following the -1.6% rate in the first quarter.
The early August release by the U.S. Bureau of Labor showed a booming job market, with new non-farm payrolls of 528,000. This was more than double consensus estimates. The strength of the labor market may be seen as a cushion against a recession, with a potential mitigation effect that could make a recession shallow and short.
One other significant piece of data is consumer expectations of inflation. The Fed has previously indicated it pays a great deal of attention to this forward-looking number. The 75-basis point rate increase in June was in part deemed necessary because consumer expectations for ongoing inflation had increased. The University of Michigan Consumer Expectations Index in July showed consumers think inflation will decrease.
July CPI (released August 10th) showed a decline to 8.5% year over year. Core CPI, excluding food and energy, increased 0.3%. This is a smaller increase in core CPI than we saw in April, May or June. But it’s still headed the wrong way.
How Did the Credit Markets React?
Despite a 150-basis point increase over two months in the Fed funds rate and persistently higher inflation, the benchmark 10yr Treasury yield dropped 37 bps to end the month at 2.65%. This is 83 bps below its 2022 peak. The rally was sparked by investor sentiment that the Fed’s view was becoming more dovish, which the Fed worked hard to counter towards the end of the month. By month end, the 2-year – 10-year segment of the yield curve inverted as investors began to price in the potential for a recession.
The Bloomberg U.S. Aggregate Index followed up the worst first half since the inception of the index with a positive return of 2.44% in July. It’s still in negative territory for the year. All major fixed income sectors turned positive for the month, but remain underwater.
A Closer Look: How Meaningful is the Data?
The Fed keeps talking about “evolving data,” and new releases of data that reflect smaller subsets of the economy make headlines daily. The economic commentariat then weighs in on how this or that piece of data relates to future expectations for the economy or what the Fed will do. What does it all mean? What is the big picture?
For investors, whether we are officially in a recession isn’t as useful a measure for guidance as a look at some recent performance history. Traditional credit assets have struggled all year, and persistently high inflation and a hawkish Fed means those assets are more likely to continue to be a drag on the 60/40 portfolio.
Demand has increased from investors that want to expand the credit spectrum in their portfolios with alternative private credit assets that could provide further diversification to traditional public credit assets.
Floating rate assets that can mitigate the risk of rising interest rates, including direct lending and leveraged loans, continue to see interest.
Performance Among Credit Indices
Source: Bloomberg as of 8/1/2022
Chart Spotlight: Inflation Expectations are Ever-So-Slightly Heading Down
Consumers expectations for inflation decreased in July from a peak in June – but 6.2% isn’t even remotely close to the Fed’s long-term goal of an average of 2%, and even over the medium term prices are expected to be elevated.
New York Federal Reserve Survey of Consumer Expectations
Source: New York Fed Survey of Consumer Expectations
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