The markets will rapidly price in a more dramatic Fed easing path if the latest batch of jobs data due to be released this Friday reveals a jump in the unemployment rate.

Danielle DiMartino Booth, chief executive of Quill Intelligence and a former Dallas Federal Reserve Bank adviser said as a rule of thumb, a 0.3 per cent increase in the unemployment rate is typically associated with recession.  “If markets get irrefutable proof the US economy is sliding into recession, it could be the first time in a while that US stocks did not celebrate bad news as good,” she said.

According to the bond expert, who will deliver the keynote speech at Investment Magazine’s Fixed Income and Credit Forum on August 27-28, if the Fed aggressively cuts rates by 50 basis points in July, it would be due to unemployment data deteriorating at a pretty fast rate.

“We’re seeing some nasty turns in the jobs survey data,” she added. “Working class Americans have started to take note of less job availability. Every time we’ve seen increases of the magnitude, we’re currently seeing in the survey data, it has coincided with a dramatic and rapid rise in the unemployment rate,” she said.

DiMartino Booth further said whether US suffers a plain vanilla economic recession or a global financial crisis will depend on whether there is a ripple effect.

Right now, she finds it hard to say exactly where the damage will come from.

For a start, the growth of bonds rated triple-B are very risky. The US capital markets are flush with triple-B debt that should, but isn’t, being downgraded by the ratings agencies.

It’s very problematic,” she warned.  “The rating agencies should have downgraded a good one-third of these bonds to junk at this point but they are holding the line and giving them a stamp of approval.”

She is concerned about the massive growth of the triple-B bonds -the lowest rung on the investment grade ladder. Together with lower rated paper, the market is massive. DiMartino Booth said that market is estimated to be twice the size of the subprime mortgage market in 2007.

Worse, almost 40 per cent of US triple-B rated bonds will need to be refinanced within the next three years.

Plus, she added, there are certain structures that hold credit in the US that have not been tested. “The fact that investment grade ETFs have theoretical instantaneous liquidity is very problematic especially when in November and December a lot of these underlying bonds traded by appointment only,” she noted.

“You’re talking about a US250 trillion global debt market so the Fed must keep the credit market volatility genie inside of the bottle at all costs.”

The big fear is the bond market is first mover in a crisis – and that equities will follow. What’s interesting to the research and analytics expert is that high yield spreads have not come in even though there has been a crash in the yield of the benchmark 10-year treasury.

“It’s very telling now that the credit market is advertising a higher level of stress than the stock market and these are not situations that can go on indefinitely,” she said.

“The bigger risk is a potential feedback mechanism whereby if companies begin to deleverage record high levels of debt, that would begin to pull the plug on share buybacks. It is game over if that happens in the US stock market.”

Equities are well-behaved right now after a record first quarter of share buy backs. “But right now, we’re seeing layoffs spread throughout the economy,” she said.

Danielle DiMartino Booth will be speaking at the Investment Magazine Fixed Income and Credit Forum on August 27-28 at the RACV in Healesville, Victoria.

 

 

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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