Market Commentary

The Fed Moves its Strike Price Higher

• The implication of the above is that dips will be faster and likely shallower.

• While the labor market may continue to deteriorate, the Fed’s new reaction function will remain supportive of risk assets.

• We remain in a mid-cycle bull market.

Despite a 50-baisis point cut last week, we know the U.S. economy is in decent shape, inflation (and rates) continues to come down, and while the labor market will likely cool more (higher U3 dot), it likely will not roll over soon.

Thus, Pinebrook remains of the view that the U.S. economy remains in a mid-cycle state and stocks will continue to rally into the calendar year-end, never in a straight line of course.

This view is reinforced by credit spreads in general, and by trash spreads in particular.

There is more information value and a higher signal between a general index and the lowest rated tranche of the same index, than in just in an index alone.

Thus, we consider the relationship between the investment grade credit index and the BBB tranche, and the relationship between the high yield credit index and the CCC tranche, as being more informative of the business cycle than a stand-alone index.

In the investment grade space (IG), rates have been climbing since their spring lows.  This likely reflects the slowing of the economy and growth scare that was flagged as a high probability during that time.

High yield (HY) credit on the other hand, is basically back at its spring lows, while the CCC tranche has been steadily climbing.

The following table provides more context to the data.

The spot IG trash spread of 23-basis points is at levels consistent with the post-pandemic boom of 2021.

On the CCC side, there is room for compression should the economic cycle pick up.

To the extent that credit spreads are informative of anything (certainly not the future), we can infer that the current state of the business cycle is still in expansion territory despite the recent slowdown in the labor market that has been occurring.

While slowly then suddenly is always a possibility with respect to a widening in credit spreads, it is not Pinebrook’s base case given the raising of the Fed Put strike price.

One reason is that the internal volatilities of the rate complex will continue to come down as policy certainty and the reaction function are now more transparent.  This will fuel a contraction in credit spreads and support downstream financial assets.

The 30-day standard deviation of 10-year nominals, reals, and term premium have been in decline year to date.  Some of this is an echo of when the Fed announced a formal end to their hiking campaign and signaled the start of the cutting cycle to commence in 2024. 

Most notable is the collapse in term premium volatility.

With cyclical concerns out of the way, we turn our attention to equities.