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Fed Loses Grip on Debt Markets?

Friday August 21st, 2015   •   Posted by Craig Eyermann at 5:57am PDT   •  

39891165_S Bloomberg‘s Lisa Abramowicz is asking the question, “What happens when the Federal Reserve loses its stranglehold over debt markets?” Which after having order break down in the U.S. stock market yesterday, after having held for the previous four years, is a pretty good question to ask.

More specifically, she’s looking at the nation’s corporate debt markets, where she identifies a growing cause for concern:

The selloff in corporate bonds is deepening and investors are seeking safety in the longest-dated government debt, which does best when the economy does worst. Defaults are rising as oil tumbles and investors are looking for the best ways to hedge against credit losses.

All this comes as the Fed does, well, nothing much. Instead, it’s China that’s taken the lead with new rounds of financial stimulus in the face of slowing growth. But some days it’s a free for all, with even Kazakhstan wielding its influence….

Investors have sent yield spreads on U.S. junk bonds up 0.64 percentage point this year to 5.68 points, according to Bank of America Merrill Lynch index data. Those on speculative-grade energy securities have surged to 9.64 percentage points, close to the most since 2009.

Instead, investors are piling into Treasuries that mature in more than 15 years, with that debt returning 2.1 percent so far this month and yields falling toward the lowest since April. BlackRock Inc.’s $5.5 billion exchange-traded fund that focuses on longer-term U.S. government bonds received $447.7 million of deposits in the past week, the most among its fixed-income peers, data compiled by Bloomberg show.

Recall that the yields, or interest rates, that investors receive when they loan money to corporations or governments through the bonds they issue rise when the likelihood of a default increases, which is what we’re seeing in the corporate bond market, particularly with the bonds issued by energy-producing firms.

At the same time, when investors come to expect that the overall economy is worsening, instead of seeking out places in the private sector to invest their money, they will simply park it in bonds that they believe have near-zero risk of default. In this case, U.S. government-issued debt securities, where the longer-terms of the bonds they’re buying suggests that they don’t expect a better opportunity for investing for another 15 years or longer.

Mike Shedlock looked at the impact of the Fed’s apparent loss of control over the U.S. Treasury’s yield curve, where he notes that rising short-term rates and falling long term rates are a pattern that is consistent with a growing risk for recession.

Rate Hike Odds Shift to December

The Fed has been trying for months to convince the markets that rate hikes are coming in September. On Thursday the market took another look and came around to my point of view “I’ll believe it when I see it”….

Synopsis Since January 2014

The short end of the curve (2- and 3-Year) acts as if hikes are coming.
The middle of the curve (5-year) seems ambivalent.
The long end of the curve (10- and 30-year) acts as if rate hikes are not coming or alternatively a recession approaches.

For the U.S. government, that’s a mixed outcome because while it reduces the amount of money that it costs to borrow in the long term, rising short term rates will cost the government more. With nearly 72 percent of its publicly held debt maturing in less than five years, it’s likely that the total amount of interest it pays on the debt securities it issues will increase.

That dynamic means that less money will be available for U.S. politicians and bureaucrats to spend as they like. And because they would really like to spend more, that means that they’ll be looking to either hike more taxes or borrow more so they can. Especially if they can exploit the onset of a new recession they helped ensure through their past policies to justify new spending.

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August 2015