Investors betting on a dovish Fed pivot are in a tricky dance, Goldman warns

A powerful rally in U.S. stocks has been unleashed this month as more investors bet the Federal Reserve’s move away from aggressive interest rate hikes has gone “too fast, too early” for debt tied to big US corporations, a team of credit researchers at Goldman Sachs has warned.

The emergence of “a dovish Fed view” could come back to bite investors, given that the Federal Reserve “has yet to see any concrete evidence that inflation is under control,” the credit team wrote. of Lotfi Karoui at Goldman, in a weekly note. .

“We continue to fade the rally and recommend using it as an opportunity to reduce
risk and move the quality upwards.

A spike in inflation to its highest level in four decades has weighed on households, especially those in the lower income brackets, while higher borrowing costs, designed to cool demand for goods and services, have yet to dampen demand for scarce cars or items like Apple Inc.’s AAPL,
+3.45%
iPhone.

Corporate profits, however, fell from record highs as tighter financial conditions and recession fears fueled a dramatic rout in stocks and bonds in the first half of the year.

In July, corporate bond spreads widened, accelerating after the Fed raised rates an additional 75 basis points on Wednesday in a bid to quickly rein in high inflation. President Jerome Powell, during an afternoon press conference, argued that a slowing economy does not mean the United States is in a recession right now, especially with its labor market. solid work.

Past recessions have often been accompanied by wider bond spreads, on fears that a declining economy could further squeeze spreads, but also that liquidity could dry up and lead to more corporate defaults.

At last review, high-quality corporate bonds considered to have relatively low risk of default were rewarding investors a difference of approximately 1.54%or premium above the risk-free Treasury rate TMUBMUSD10Y,
2.641%,
according to the ICE BofA US Corporate Index. That’s down from a high of 1.65% so far this year, but a nearer low of 0.86%.

High Yield Spreads closed 90 basis points, or nearly 1%, from July’s widest levels, according to Goldman data. The S&P 500 SPX index,
+1.33%
and the Nasdaq COMP composite index,
+1.74%
Friday were poised to book their best month in nearly two years.

Part of this rosier backdrop has been the view by some investors that the Fed will erase (see chart) at least some of its planned penciled-in rate hikes by the end of next year.

Corporate bond spreads imply less Fed rate hikes

Goldman Sachs Global Investment Research

The Fed indicated in June that its key rate should reach around 3.5% by the end of 2022 and 4% in 2023, which would represent a sharp increase from its current rate. Range 2.25% to 2.5%.

While a “decline in inflation measures could surprise positively in magnitude, we struggle to see a sustained compression in risk premia, and hence an easing in financial conditions,” the Goldman team wrote. .

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