Rates and Currency Action Showing Stress on Financial Systems

1. Bond Market Volatility Impacted by BoE and PCE. Last week saw historically large moves in fixed income markets, driven by both the Bank of England’s (BoE) decision to launch an emergency bond repurchasing program to bail out UK pension funds and continued hot Core PCE readings in the US (+4.7% v. Est. 4.4%). The Core PCE is the Fed’s preferred measure of inflation, which will continue to underscore the Fed’s hawkish narrative. Even as parts of the economy are slowing, like housing, inflation has not retreated – driven by sticky components like household and other services which are, in turn, driven in part by rising wages. 

On Wednesday, mortgages rallied 1.89%, while Corporate Investment Grade (LQD) rose 2%, both of which are the best single-day returns in history. The 10-year Treasury yield rose above 4% on Wednesday afternoon for the first time since 2010, then rallied to end the week at 3.75%. Corporate spreads widened through the week, High Yield by 50 bps and Investment Grade by 19 bps, finishing the week at +550 bps and +189 bps, respectively. Municipal yields rose 10-15 bps across the curve, with the larger moves seen in the short end. Lipper reported an eighth consecutive combined monthly outflow in municipals, resulting in a cumulative year-to-date outflow of ($91.5bn). 

2. Bank of England (BoE) Throws a Life Preserver. Britain’s new government introduced a “mini budget” that would reduce taxes and increase levels of debt. This created acute financial instability as rates surged and the pound plunged. Pension funds, which represent a significant percent of Great Britain’s GDP, were at risk – being required to pay collateral on “underwater” derivative positions. The system quickly became non-functioning as pension funds searched for cash to pay off these “liability-driven investment” (LDI) hedging instruments. The BoE stepped in as a buyer, spending 65 billion pounds toward long-dated securities to slow the surge in rates. 

It was nearly a contagion event, and at the end of a turbulent week, many pension funds were still liquidating positions to meet collateral requests. While the BoE may have stopped an immediate crisis by sending yields back to prior-week levels, experts say that Britain is not out of the woods, and uncertainty will remain when the BoE steps out of the market on October 14. On Friday, S&P cut the AA credit rating for British sovereign debt from “stable” to “negative.” 

Chart 1: UK Bond Yield Spreads¹ 

Significant volatility has also been experienced in U.S. credit markets – as blue-chip U.S. credit markets have their worst year ever, money becomes tighter and credit spreads widen. Margin calls and forced liquidations could add further stress and chaos. The Fed is having an emergency meeting this week. 

Markets are forward-discounting mechanisms, and the selloff has created opportunity for long-term investors – high yields in high-quality credit markets and historically attractive valuations in market-leading equity names. 

3. U.S. Dollar Strengthens: Cycle of Risk. Investors continue to seek haven in the U.S. dollar as economic risks rise globally. On Friday, demand for USD in currency derivative markets surged to its highest level since March 2020. 

As a country of importers, the U.S. consumer is able to purchase foreign goods for lower costs. American consumers are beneficiaries of the trends while exporters are at a price disadvantage, selling their products in international markets and converting those revenues into USD at a lower value. 

Many countries issue USD-denominated debt and then service that debt with local currencies – a difficult situation with the USD strengthening and interest rates rising. In summary, investors are flocking to the U.S. dollar because of the rising global economic risks, and U.S. dollar strength further stresses global financial stability. 

Chart 2: Currency Performance² 

4. OPEC+ Expected to Announce Production Cut. OPEC+ members convene in Vienna on Wednesday, and they are expected to announce a second-sequential production cut. A production cut is likely to be less impactful than the amount announced, because the group has consistently fallen short of their existing targets. The group is said to be considering cutting output by more than 1 million barrels per day. 

Chart 3: Theory and Practice³ 

Meanwhile, the Biden administration has continued to tap the U.S. Strategic Petroleum Reserves (SPR) – a program set to complete at the end of October. U.S. emergency oil reserves are now at their lowest levels since 1984, while U.S. commercial crude inventories are below average, despite the SPR releases. 

5. The Week Ahead. 

Earnings – Thursday: CAG, MKC, STZ, LEVI 

Economics – Monday: Fed Emergency Meeting, ISM Manufacturing (September). Tuesday: JOLTs Job Openings (August). Wednesday: OPEC+ Meeting, ISM Services (September). Friday: Nonfarm Payrolls and Unemployment Rate (September). Reuters (chart)

Stephanie Link: CNBC TV Schedule 

Return for Selected Indices⁴ 

Sources

1. Reuters (chart)
2. Reuters (chart
3. Bloomberg (chart)

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