Brace For Rate Impact As Fed Drops Duration Shield

Authored by Simon White, Bloomberg macro strategist,

The full force of the rate-hiking cycle is about to be felt across the economy as the Federal Reserve pulls back from warehousing duration risk, leaving the private non-bank sector acutely exposed to higher rates, and credit spreads prone to significant widening.

There has been no shortage of surprises in this cycle. For one, it is remarkable that despite the fastest series of rate hikes for decades, equities are less than 15% off their highs, the VIX is little changed from when the bear market started, and credit spreads are not wider.

But, like a cyclist at the front of a peloton, the Fed has been shielding the economy from the full, and mounting, headwind of higher rates.

Now, though, the central bank, after making perhaps its last hike of the cycle on Wednesday, is pulling to the side and allowing the rest of the economy to face the impact on its own, deepening a recession that may already be underway. Wider credit spreads will be the main adjustment mechanism, as non-bank private-sector balance sheets come under greater stress from rising interest-rate risk.

The Fed’s duration-shedding program – QT – began last summer. As it progressed, it was anticipated that banks would shoulder much of the burden, increasing their ownership of USTs, MBS and other debt securities.

Instead they have also been shedding duration risk, and at an increasing rate. The net effect is that it is the non-bank private sector – corporations and households – absorbing ever more duration, meaning the hitherto dampened effect from rate rises is about to intensify.

The chart below shows the stark difference between the 2008 recession and the state of play today. Back then, both banks and non-banks owned a much larger proportion of debt securities, while the Fed’s QE program was only in its embryonic stages. That recession was one of the longest and deepest seen for many years as the brunt of higher rates, transmitted through wider spreads, was absorbed by the bank and non-bank sectors.

But this time around the Fed and banks are jettisoning duration risk, while corporates and households are becoming increasingly exposed to higher rates, with this exposure accelerating in recent quarters. The vestiges of central-bank protection are fading.

That’s not likely to change any time soon. The Fed has given no hint it intends to curtail QT (although the new BTFP facility can act as a standing buffer if financial stress worsens), and banks look set to keep selling their bonds. The chart below shows that higher Fed rates lead to banks lowering their exposure to debt.

On top of that, the non-bank sector is facing a rapid squeeze in credit availability from banks. As this week has reminded us, lenders have been at the sharp end of the Fed’s rate hikes. That’s especially the case with smaller banks, who loaded up on “safe” assets to meet regulatory constraints, while neglecting to hedge the interest-rate risk properly (as perhaps they forgot rates can actually go significantly above zero).

Credit conditions have been tightening as smaller banks lose deposits, while larger banks are reluctant to take them, meaning high-velocity bank deposits ultimately end up in the lower-velocity world of money-market funds and the RRP.

Smaller banks’ distress should come as little surprise given the yield curve. As long-term lenders and short-term borrowers (while owning fewer interest-paying Fed reserves than larger banks), the degree of the yield curve’s inversion highlights the pressure on smaller banks’ margins.

But the inversion has also allowed the Treasury to increase the duration of its debt, with the result that the average duration of Treasury debt held by the public is now at 20-year highs.

As banks keep selling their UST holdings down, the non-bank public is owning an increasing proportion of this longer-maturity debt, amping up its interest-rate risk even further.

Normally wider credit spreads follow soon after yield-curve flattenings. However, in a clear-cut sign the Fed has been cushioning the economy from the bulk of rate hikes, we have seen one of the deepest yield-curve inversions in over 40 years, while credit spreads have widened only modestly.

But that’s about to change, and spreads will soon begin to reflect the economy’s true duration risk. It’s never fun at the front of the peloton.