Inflation vs. Liquidity

The news flow about inflation keeps intensifying this week. All of our research analysts heard companies talk about pushing through price increases to overcome cost increases related to global supply chain disruptions. The fixed income market reacted sharply to increased inflation expectations and by the end of the week, the market had priced in two rate hikes by the end of 2022.

One would think that such a sharp increase in rates should a) result in lower bond prices and b) increase concern of an outcome where the Fed has to modify its intended policy path. This could create outflows and sharply negative returns in fixed income products like corporate bonds.

We looked at the bond portfolio underlying the HYG ETF (a proxy for the US high yield credit market) and found the weekly changes in price and spreads to be very modest. In fact, spreads, which are ostensibly a barometer of credit risk, actually tightened.

^{Source: Aperture Investors LLC, Bloomberg}

Spreads tightened more in the short end of the curve – almost perfectly compensating for the move wider and flatter in the treasury yield curve. The credit markets seem to be telling the macro community that it is business as usual and that risky asset investors are not too fussed about the Fed losing control of the narrative as the macro/rates markets. So who is going to be proved correct in the next 3 to 6 months?

For now, there is an incredible amount of liquidity still in the system and there is a lot of cash on the sidelines to dampen the effect of rates adjusting to these new levels.

Absorbing such a sharp widening in rates last week should be quite reassuring for credit investors, but it is undeniably the case that we are approaching the end of the spread compression. 2022 promises to be a more trendless volatility regime for credit investors than the post-COVID-19 period has been.

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Originally Posted on October 26, 2021 – Inflation vs. Liquidity