Credit Musings: November 7, 2022

Nov 07, 2022


Public Trust Credit Team

U.S. midterm elections will be held this week, with major implications for economic and financial policy.

Despite many elections still being too close to predict, the general consensus is that Republicans are expected to take slight majority control of both the Senate and the House, thus creating a divided government. This would mean that the White House will have much less flexibility when it comes to financial policy, and will face tougher hurdles on spending, as well a looming showdown over the debt ceiling. As soon as early next year, Congress must gather enough votes to raise the ceiling to avoid national default. While this would no doubt be catastrophic for the global economy, Congress can essentially use the threat of defaulting as a bargaining chip; similar to 2011, when a compromise was achieved just days before the debt limit was hit. Other highly contentious points of financial policy include the IRS funding bill, military aid to Ukraine, spending related to the Inflation Reduction Act, social security, and a Federal omnibus spending package that is required to keep the government open past December 16. While nobody can predict the results of these elections with certainty, lawmakers on both sides are already bracing for extreme political gridlock, at least until the next election cycle.

Technology makes its way to the bond market (finally) improving liquidity.

With apps like Robinhood and more brokerage websites than we could possibly name, people can trade stocks from the comfort of their couches instantaneously. However, the bond market has never embraced these new technologies and most trades are done over the phone. The winds are beginning to change though, and electronic bond trading recently hit its highest level ever in September which brought a fresh boost of liquidity to the market. According to Bloomberg, $15 billion of investment-grade bonds a day were traded electronically in September setting a new all-time high when compared to the previous record of $12.7 billion a day in 2021. Investors had expected a liquidity crunch from the Fed’s rate hikes, but the volume of electronic trades made investment grade debt one of the more liquid markets during what would normally be a very illiquid time. Our preferred measure of liquidity, bid-ask spreads, have stayed well below their recent peak in March 2020.  Moreover, they have remained below the level seen during the last rate hiking cycle when the Fed was moving much slower. Much of the increased adoption is due to more sophisticated algorithms that assist in large block trades. Many of the algorithms that the banks use have been refined and learned from prior liquidity crunches, like in 2020. In fact, Bank of America estimates that it is doing twice the volume in its algorithmic trading division than it was doing just two years ago. The increased adoption of electronic trading should be positive for liquidity in the investment-grade market moving forward, and all signs point to banks and traders using the technology more frequently to get better pricing and move larger and larger blocks of bonds. 

The avoidance of a recession could be a legitimate possibility.

Goldman Sachs Group’s top economist said there exists a “very plausible” path in which the U.S. can prevent a recession. The bank has forecasted a 35% chance the U.S. will enter a recession within the next year which sits comfortably below other Wall Street expectations. Items that need addressing include a moderation in economic activity, a slowdown in nominal wage growth, easing of inflation, and a rebalancing of the labor market. The Federal Reserve has continued to raise interest rates with the end goal of cooling price pressures. Chair Jerome Powell announced the rate hike of 0.75 last week, ultimately signaling slower increases, but higher rates. The U.S. is performing a balancing act between correcting these economic issues while simultaneously staying in control as to not over correct. Another key economic indicator of an imminent recession is the city of Philadelphia’s baseball team winning the World Series. The Philadelphia Athletics 1929 and 1930 championships coincided with the Great Depression, while the Phillies’ 1980 win came amid the energy-crisis fueled downturn, and the team’s most recent World Series victory happened at the start of the Great Recession. Although the causal relationship is uncertain, the Houston Astros did their part in protecting the U.S. economy by taking home the title against Philadelphia Saturday night. Now that Houston has managed to keep the baseball domino from tipping, it will take the effort of slightly more prominent bodies of power to prevent the rest from falling. 

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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