Credit Traders Gird for the Worst as Fed Loses Its Grip on Debt

What happens when the Federal Reserve loses its stranglehold over debt markets? Investors are finding out.

The selloff in corporate bonds is deepening and investors are seeking safety in the longest-dated government debt, which does best when the economy does worst. Defaults are rising as oil tumbles and investors are looking for the best ways to hedge against credit losses.

All this comes as the Fed does, well, nothing much. Instead, it’s China that’s taken the lead with new rounds of financial stimulus in the face of slowing growth. But some days it’s a free for all, with even Kazakhstan wielding its influence.

“Financial markets are desperate for the Fed to drive trading themes, but the ‘world’s central bank’ has fallen to the second rank this summer,” or sometimes third, Jim Vogel, an interest-rate strategist at FTN Financial in Memphis, Tennessee, wrote in a note Thursday.

Benchmark U.S. interest rates are still at about zero, and even if the Fed makes a move this year, it’ll only increase those rates by a fraction of a percentage point. In other words, U.S. monetary conditions are still very easy, more than six years after the worst financial seizure since the Great Depression.

‘Policy Error’

And perhaps this is precisely the problem: the Fed may have waited too long to back away from its crisis-era policies, and it now has ceded control to the next default cycle and the whims of other global central banks. That’s being treated as bad news by credit buyers, who are now demanding close to the highest premium to own junk bonds instead of government bonds since 2012.

“The Fed was ready to move, waited too long, and China moved first,” wrote Wells Fargo & Co. analysts led by Richard Gordon on Aug. 18. “Now it’s up in the air as to whether a rate tightening by the Fed -- any rate tightening -- will be viewed years later as a major policy error, or a much needed push towards the normalization of monetary policy.”

Investors have sent yield spreads on U.S. junk bonds up 0.64 percentage point this year to 5.68 points, according to Bank of America Merrill Lynch index data. Those on speculative-grade energy securities have surged to 9.64 percentage points, close to the most since 2009.

Instead, investors are piling into Treasuries that mature in more than 15 years, with that debt returning 2.1 percent so far this month and yields falling toward the lowest since April. BlackRock Inc.’s $5.5 billion exchange-traded fund that focuses on longer-term U.S. government bonds received $447.7 million of deposits in the past week, the most among its fixed-income peers, data compiled by Bloomberg show.

And bond buyers are trying to shield themselves by holding more cash and buying protection via credit-default swaps.

Investors are finally getting a glimpse of what markets look like when the Fed no longer has a vise over every price movement -- and many are getting nervous about what they’re seeing.