Terminal rate spook, crypto dissolve, and Netflix credit warning
Head of Equity Strategy
Summary: The past week has been dramatic with the Fed's terminal rate in June 2023 being repriced a full percentage point to 4% suggesting that the FOMC will likely go 75 basis points tomorrow and again next month in order not to get behind the curve. The equity market is responding with a fresh selloff wiping out the gains from the recent bear market rally. Cryptocurrencies are in a state of shock over the fallout in "stablecoins" and now recently a big crypto lender causing spill over effects into equities. Finally, we are talking about high yield and highlighting Netflix as a sign of the tighter financial conditions even for big companies.
New market low but still no panic
Unlike many of the previous setbacks in global equities since early 2015 this drawdown, that has now officially taken S&P 500 into bear market, has been orderly in the sense that the VIX forward curve has been well-behaved. But yesterday’s price action took the VIX Index 34 which inverted the VIX forward curve the most since the late April selloff. However, the inversion has still not reached levels where suddenly the market snaps and it moves into intense selling driven by illiquidity and volatility hedging. But yesterday’s price action was definitely a warning to investors.
Today S&P 500 futures are bouncing back together with crypto with the latter likely being the main source of injecting fresh risk-off sentiment into equities as a large crypto lender suspended withdrawal (see yesterday’s equity note for a discussion) and later during yesterday’s session Binance suddenly temporarily halted withdrawal spooking the market. Like a heat-seeking missile the Bitcoin market was moving towards that $21,000 level that has been highlighted as approximately where MicroStrategy would begin getting margin calls on its massive Bitcoin position which is used as collateral for several bonds. As the market got no news about margin calls despite Bitcoin breaking below the $21,000 level it turned around and positive risk sentiment spilled into equities.
The culprit of the latest big moves in risky assets such as equities, real estate, crypto and high yield bonds has undoubtedly been the pricing of the Fed’s terminal rate measured by the expected Fed Funds Rate by June 2023. The market pricing was rather stable during April and May after the initial selloff in Fed Funds Rate futures Jun23 (see chart below) indicating around 3% terminal rate, but the market has moved another 1%-point in just a little over two weeks to 4%. This move and the underlying stickiness in core inflation have caused chills down the spines of Fed members because it is likely pressuring them to go 75 bps. tomorrow and again next month adding considerable pressure to short-term funding rates and potentially also on longer term interest rates adding more pressure to equity valuations.
Talking about interest rates it is worth noting some deteriorating signs such as the Netflix April 2028 4.875% bond is now trading as low as 93.345 which is only 3.4% from the lows during the height of the pandemic stress in the market. Not a good sign in the credit market for a big name such as Netflix that is a $30bn recurring revenue business. But Netflix is increasingly using debt to finance its content creation, which by the way has been declining in quality lately, as it is cheaper than equity and it has enabled Netflix to accelerate production that would otherwise have been impossible from its operating cash flows. While we are not overly concerned over the rising rate on Netflix’s bonds as it represents a general move higher in interest rates it is worth keeping an eye on credit market. Global high yield spreads have widened considerably this year to around 424 bps. which is a bit off the around 500 bps. that would set off the alarm bells.
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