The Perceived Problem
While the Fed’s purchase programs succeeded in providing corporations with credit and stabilized markets during the pandemic-related economic crisis, it raised expectations that the Fed could intervene again, ring-fencing corporations from future economic shocks. That might artificially cut the cost of credit and encourage companies to overleverage, sowing the seeds of a future crisis.
Investor expectations of an enduring “Fed put” for US corporate bonds could also affect the success of various investment strategies by reducing credit spread widening during periods of economic and financial market volatility.
U.S. Market Metrics Provide No Evidence of a “Fed Put”
- Credit spreads and volatility were within historical ranges post the pandemic recovery in financial markets.
- Credit spreads were close to levels suggested by fair value models.
- Option skew was steeper than we would expect if investors were counting on a Fed put.
- Recent spread widening is consistent with a slowing economy.
The lack of evidence in market-pricing of a “Fed put” suggests the market may see the Fed’s 2020 corporate bond purchase programs as a response to an extreme crisis and unlikely to recur in a runof-the mill recession.
The market may also believe that legal and political constraints make future credit interventions highly unlikely in the U.S. The Fed’s rapid unwinding of its corporate bond holdings in 2021 also suggests that the Fed retains its traditional aversion to interfering in credit allocation.
Post-Pandemic Credit Spreads not Unprecedented
As of June 30, 2022.
Source: UBS, used with permission.
Euro-Area Market Provides Some Far-from-Conclusive Evidence
- The median spread for BBB-rated corporates and spread volatility have been lower since the ECB began intervening in 2016 than in prior years.
- Euro area investment-grade spreads were tight relative to modeled spreads in March 2020.
The market may have expected the ECB to scale up corporate bond purchases if necessary to ensure business access to credit. The ECB had started an ongoing corporate debt program in 2016 and resumed purchased in late 2019, after a pause. There were no legal or political barriers to it doing more.
But there are other potential reasons for the decline in euro-area credit spreads and spread volatility after the ECB program began in 2016. Most simply, nothing bad happened to rattle the market until the pandemic, while the prior decade included both the Global Financial Crisis and the European Sovereign Debt Crisis. ECB rate cuts and its launch of sovereign quantitative easing in 2015 could also explain the decline in spreads and spread volatility, as investors took more risk by moving down in quality in response to lower interest rates.
What to Watch
It is possible that market expectations of a Fed put might only become apparent when a recession or financial crisis looms. It is worth monitoring how spreads, model valuations and option prices evolve, particularly as investors focus on whether the Fed’s rapid rate hikes this year will lead to a recession.
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NOTE TO EUROPEAN INVESTORS
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