Home / News / World /  US Fed rate hike: Market red flags that may prompt US central bank to tone down
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As investors brace for a hefty rate hike from the US Federal Reserve and clues on further hikes, the Fed is set to announce its decision at the end of a two-day policy meeting later today. It is expected that it will raise the rates by another 75 basis points to a range of 3 per cent to 3.25 per cent -- which would be the third consecutive increase of that magnitude. Fed policymakers have been reiterating their commitment to bring inflation down which holds close to levels not seen in 40 years.

US Federal Reserve Governor Christopher J. Waller recently gave a hint 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 key issue of inflation for other potential market metrics that may cause the Federal Reserve to slow its aggressive cycle of interest-rate hikes.

Stress on credit markets from monetary tightening

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

Higher borrowing costs

Higher borrowing costs and a decline in equity prices since the middle of August have tightened U.S. financial conditions to levels not seen since March 2020, according to a Goldman Sachs benchmark composed of credit spreads, stock prices, interest rates and foreign exchange rates. 

Increasing risk of default on corporate debt

The spread on the Markit CDX North America Investment Grade Index, a benchmark of credit-default swaps on a basket of investment grade bonds, has doubled this year to around 98 basis points, inching closer to its 2022 high of 102 basis points set in June.

The increasing risk of default has been closely correlated with the surging dollar, which is benefiting from the rapid pace of Fed interest-rate hikes.

Shrinking Treasury liquidity

Another threat that may prompt the Fed to slow the pace of tightening is shrinking Treasury liquidity. A Bloomberg index of liquidity for US sovereign is near its worst level since trading virtually seized up due to the onset of the pandemic in early 2020. 

Thin bond-market liquidity would add pressure to the Fed’s efforts to reduce its balance sheet, which ballooned to $9 trillion through the pandemic. The central bank is currently letting $95 billion in government and mortgage bonds roll off the balance sheet every month, removing liquidity from the system.

Currency markets

A fourth area that may cause the Fed to think twice is the growing turmoil in the currency markets. The dollar has powered ahead this year, setting multi-year highs against almost all its major counterparts and driving the euro below parity for the first time in almost two decades.

The US central bank typically ignores the dollar’s strength, but excessive declines in the euro may fuel concern about worsening global financial stability. 

-With inputs from Bloomberg



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