Is the Fed finally going to turn?

With the collapse of the UK market and the Bank of England being forced to turn to buying bonds again in the face of runaway situations to stabilize market confidence. Some institutions on Wall Street are beginning to think that the Fed should bail out the market.

In a recent report by Bank of America Corporation's high-yield bond strategy team, analysts Oleg Melentyev and Eric Yu believe that the depth and breadth of the current dilemma and the ratio of debt to corporate value are higher than they expected. The credit stress indicators compiled by the bank have currently been pushed to the "critical zone":

Our credit stress index (CSI) rose 4 points to 74 this week. This level exceeds the June peak of 71 and is on the edge of the 75-point borderline. Most of the companies in the index have stopped issuing new bonds, and the cost of issuing is already at an all-time high.

The Fed began buying corporate bonds after the COVID-19 outbreak in March 2020, when the Fed's move saved the trillions of dollars market. Now, however, the Melentyev team believes that the Fed's current aggressive monetary tightening measures may be the most critical factor forcing the Fed to slow the pace of monetary tightening.

The team believes this is because with CSI reaching the "critical zone" of more than 75 per cent, the Fed will have to strike a balance between its inflation control target and the risk of unintended consequences that disrupt bond market flows.In fact, the yield on 10-year Treasuries has risen 50 basis points since last Thursday, 3.5 times the standard deviation, hitting 4.0% on Wednesday morning, the highest level since 2008. these figures highlight the current sharp tightening of the credit environment in the United States and will put additional pressure on companies.

The rise in US Treasury yields basically coincided with the collapse of UK assets. Yields on 10-year gilts have widened by 130 basis points since last Thursday. The UK's apparent market failure reached a certain extent, and the Bank of England was forced to announce emergency policy action and buy longer-dated gilts without restrictions in order to stabilize the market.

What has happened in the UK confirms Melentyev's view:

The Bank of England is not the direct catalyst behind the market turmoil, but the tax cuts introduced by the new British government. But if central banks such as the Federal Reserve and the Bank of England had not made financial conditions so tense before then, the market reaction might not have been so severe. Rising nominal and real interest rates, a stronger dollar as a reserve currency, slowing credit flows and rising volatility all contributed to the collapse of UK financial markets.

In other words, the crisis in the UK could have been avoided if market credit conditions had been relatively loose.

So what should the Fed learn from the UK crisis? Melentyev believes that:

With the pressure on the US bond market nearing critical levels, it is time to focus on risk management. This means that at its next meeting, the Fed should slow the pace of rate hikes and then pause so that the economy can fully adapt to all the extreme tightening already in place. Otherwise, it will increase the risk of bond market failure, if this happens, the situation will become out of control.