Freefalling oil prices have created an environment of uncertainty across financial markets but turbulence should not impede the Fed from hiking interest rates Wednesday for the first time in nine years.
The Fed is expected to lift its target fed funds rate off of zero, ending a seven-year era of historic, crisis-level rate policy. The central bank Wednesday will also provide economic and interest rate forecasts that could help shape the view of interest rates in 2016.
Both the pending Fed action and the plunge in oil, down 18 percent since Dec. 4, have come together as markets are increasingly worried that widening spreads in the junk bond market could be signaling a weakening economy and a rougher time for stocks. Credit markets became even more nervous Thursday over the liquidation of distressed debt fund – Third Avenue Focused Credit Fund, which halted redemptions.
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“Escaping zero — it’s a big deal. Even up to the last minute, people have doubts because things are happening, markets are moving. The odds went down,” said Tony Crescenzi, portfolio strategist and senior vice president at Pimco. “The period of stress and turbulence would happen whenever the first rate hike occurs.” Crescenzi said the market is still pricing in odds of a rate hike of more than 70 percent, but he said there is little doubt the Fed will move to hike rates.
“Whatever comes out Wednesday, even if it seems not as dovish as some hope, the harm that could come from it could seem minimal,” said Crescenzi, noting the markets do not expect rapid rate hikes and slowish global growth does not justify very high yields.
“A 25 basis point policy rate should not change any valuation model,” he said. Crescenzi said that should not be enough to sway investors from risk assets, as long as they continue to expect growth. Crescenzi said some retail investors could get anxious by the Fed move, and that could trigger some initial selling of bonds.
But some credit strategist say they do not know what to expect next week when the Fed moves to hike rates. One reason is the markets are less liquid at this time of year and the credit markets get very quiet ahead of year end.
“You don’t have a lot of trading days left in the year. We were concerned about December anyway. The Fed goes on Wednesday. You have Thursday, Friday and then maybe Monday and Tuesday. Not a lot happens around Christmas,” said Gregory Peters, Prudential Fixed Income senior portfolio manager.
The S&P 500 lost 3.8 percent to 2012 in the past week, while the Dow fell 2.5 percent to 17,265. Stocks were tethered to the volatile moves in oil, which fell to 2008 and 2009 lows. West Texas Intermediate crude futures fell through the key USD 40 per barrel level, and closed at USD 35.62 per barrel, a 10 percent decline and its worst weekly performance in a year. From a technical perspective, energy traders are watching a level for WTI of around USD 32.50, the low reached during the financial crisis.
Nuveen Asset Management’s Bob Doll said the oil shock is making it difficult to make a call on the stock market for next year. Doll, Nuveen chief equity strategist, expects oil to settle down in the next couple of weeks, but for now it’s a problem though the market volatility it’s causing should not stop the Fed from raising rates.
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Oil has been plunging since midday Dec. 4, when OPEC announced it would not cut production and would instead leave in place its hands-off policy of allowing the heavily oversupplied oil market to find its own price.
“In my view, we’ve got to stabilize the commodities market. If it keeps going down, stocks will keep going down,” said Doll. “Credit widening will stop stocks from going up, but I do not think it will cause them to go down, as oil does. It’s a yellow light, not the red light oil is.” Doll said that if credit spreads continue to widen, the Fed will be very slow to raise rates a second time.
Treasury yields in the past week edged lower as stocks sold off. The policy sensitive two-year was at 0.88 percent Friday, and the five-year yield fell Friday by 12 basis points to about 1.55 percent. The fall out from energy was apparent in the stock market with the S&P 500 energy sector down 6.5 percent for the week, and energy high yield debt saw spreads widen sharply.
“I think most people thought it would not break that barrier. When it was north of USD 40, there was an expectation or a belief that by the end of next year, we could crawl back up to USD 50 again. There are a number of oil companies that would survive at USD 50,” that would have problems with USD 40 crude, said Amundi Smith Breeden’s head of global high yield, Ken Monaghan.
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The selling in junk bonds is expected to continue, and while energy and commodities are at the heart of the selling, other sectors are also an issue.
“In the last week, we’ve seen over USD 3 billion in retail outflows (from high yield). It think it’s very concerning, and you’ve had one fund in particular that had a hard time returning money to investors,” said Michael Contopoulos, head of high yield strategy at Bank of America Merrill Lynch. He said the Third Avenue fund specialized only in distressed debt, unlike most funds.
“But the fear is investors see poor liquidity and start to withdraw their funds on the back of poor performance. That’s going to affect the market pretty dramatically.” So far, high yield has a negative return this year of 3.6 percent. Contopoulos expects a negative return of 2 to 3 percent in 2016 though BoA expects positive returns of 3 to 4 percent in investment grade bonds and a higher stock market next year.
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More energy bankruptcies are expected next year. Contopoulos said he expects 33 percent of the market value of the commodities, CCC-rated debt to default, and 16.5 percent of the higher rated B-rated commodities companies.
Doll said the markets are particularly troubled by oil’s decline because of what it may be saying about the economy. “It’s because oil is connected to the broader deflation story. Markets, risk assets in particular have to be convinced that we’ve conquered the deflation risk that’s been with us since 2008. When you get oil selling off double digits in a few days, it raises those fears again, and it’s not good for risk assets. My guess is … in two weeks, oil will be up a few bucks and it’ll feel OK.”
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Because inflation is one of the mandates of the Fed, the worry about deflation is even greater as the Fed looks set to move on interest rates.
“Without a lot of confidence, my main line scenario is stocks are doing OK, the job market is OK, consumers have much improved balance sheets. They’re going to spend some money. The corporate sector is in good shape, excluding the resources. Government spending is going to be up, and that’s going to contribute to the economy. China’s slowing down, I think it’s going to be OK. It’s not going to be ripping to the upside. I think stocks will beat bonds in this environment,” he said. Doll said as long as the economy is growing, stocks should be able to move higher.
China could also be a big story for markets in the week ahead. Besides retail sales and industrial production data on the weekend, traders will be focused on an announcement from the People’s Bank of China on its currency.
Crescenzi said it will also be important to see how the news is received that China’s central bank would like the yuan’s exchange rate to be measured against a group of currencies, rather than just the dollar. The announcement did not include any firm plans or timing for such a move.
“That will be an important part of the news of the week – how markets react to the news from China about that basket rather than a dollar peg,” he said. “The super secular notion is that it would reduce the dollar’s status as a reserve currency. The dollar is dominant followed by the euro. The Chinese currency, depending on how it stands economically, politically…it will be an increasing part of currency baskets that institutions own, but it won’t be immediate. It doesn’t have a vast bond market to store those reserves like the US does.”