US Fed rate hike: Red signals to the market that may prompt the US central bank to ease

As investors prepare for a US Federal Reserve rate hike and signs of further hikes, the Fed is set to announce its decision at the end of its two-day policy meeting later today. It is expected to raise prices by another 75 basis points to a range of 3 per cent to 3.25 per cent – the third consecutive increase of such magnitude. Fed policymakers have reiterated their commitment to reduce inflation which is holding near levels not seen in 40 years.

US Federal Reserve Governor Christopher J. Waller recently gave a hint that the decision at the monetary policy meeting will be “straightforward” and the central bank will continue to fight inflation aggressively.

Strategists are looking beyond the main issue of inflation for other potential market metrics that could cause the Federal Reserve to slow its aggressive rate-raising cycle.

Pressure on credit markets from monetary tightening

The difference between the average yield on investment-grade US corporate bonds and their risk-free Treasury counterparts, known as the credit spread, has jumped about 70% over the past year, driving up corporate borrowing costs.

High borrowing costs

Higher borrowing costs and a slump in stock prices since mid-August have tightened US financial conditions to levels not seen since March 2020, according to Goldman Sachs’ benchmark which consists of credit spreads, stock prices, interest rates and foreign exchange rates.

Increased risk of corporate debt default

The spread on the Markit CDX North American Investment Index, a benchmark for credit default swaps on a basket of investment-grade bonds, has doubled this year to about 98 basis points, gradually approaching the 2022 high of 102 basis points set in June. .

The increased risk of default has been closely linked to the rise of the dollar, which is benefiting from the rapid pace of Fed rate hikes.

Treasury liquidity contraction

Another threat that could prompt the Fed to slow the pace of tightening is the tightening of Treasury liquidity. The Bloomberg US sovereign liquidity index is approaching its worst levels since trading was virtually halted due to the onset of the pandemic in early 2020.

Thin liquidity in the bond market will add pressure to the Fed’s efforts to reduce its balance sheet, which has ballooned to $9 trillion through the pandemic. The central bank currently allows $95 billion in government and mortgage bonds to be taken off the balance sheet each month, removing liquidity from the system.

Currency markets

The fourth area that might make the Fed think twice is the increasing turmoil in the currency markets. The dollar has continued to advance this year, hitting multi-year highs against almost all of its major peers and pushing the euro below parity for the first time in nearly two decades.

The US central bank usually ignores the strength of the dollar, but the excessive declines in the euro may fuel concern about the deterioration of global financial stability.

– With input from Bloomberg

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