The Fed Holds, but the Pressure Builds

Collin Martin · Charles Schwab

Long-term yields may carry a rising term premium because the Fed's direction is unclear.

The 10-year Treasury yield rose after the meeting. Martin suspects this reflects an uncertainty premium. The term premium is the extra yield investors earn for holding longer bonds in case short-term rate expectations do not play out. Without clear guidance on where the Fed is heading, investors may demand more term premium. That would show up in higher long-term yields as investors struggle to forecast policy over the coming months or quarters. He presents this as a possible explanation, not a settled conclusion.

“We don't really know which way Kevin [Warsh] is leaning right now. So maybe you start to see more of a term premium show up in higher long term yields just because we don't really know what's happening or what to expect over the next few months or quarters.”at 7:06

Collin Martin · Charles Schwab

Reducing Treasury supply should pull long-term yields lower, and Bessent appears to favour that route.

Martin says Treasury Secretary Scott Bessent seems clearly to want lower rates. Bessent raised the Treasury buyback operation a few months ago. Martin argues that cutting supply while demand stays constant should push long-term yields down. He does not expect much change at the upcoming quarterly refunding announcement, which covers coupon issuance versus bills. He says a surprise shift in issuance mix could move yields accordingly. The view is mechanical and based on supply and demand.

“And a way to bring long term yields down is to reduce the supply because the laws of supply and demand suggest if you reduce the supply and you keep demand constant, that should pull yields lower.”at 16:53

Collin Martin · Charles Schwab

Warsh's press conference was hawkish, signalling more rate hikes despite the hold.

Martin reads Warsh's press conference as hawkish, which leans toward more hikes coming, even though the Fed held. Warsh said inflation is still too high and that financial conditions have tightened but are not tight. Martin notes the statement described the economy as strong and said the committee needs more data. He also sees a possible patient approach, since inflation expectations are described as anchored, so the Fed may not need to act as aggressively as markets expect. Short-term Treasury yields fell after the meeting, which he links to that patience.

“he made it clear that inflation's still too high, and he said that financial conditions have tightened but aren't tight. So, you know, that to me is hawkish or leans to the idea that more hikes are coming.”at 3:24

Liz Ann Sonders · Charles Schwab

AI build-out sustainability is the biggest market story, given surging capital demand and rising capital costs.

Sonders sees the sustainability of the AI build-out as the biggest macro story. Demand for capital for the build-out has increased significantly and its cost is rising. She cites Larry Fink of BlackRock saying the scramble for capital is unlike anything he has seen. She questions CapEx assumptions and whether revenue generation will keep pace with the spending. She also flags that data center restrictions have become a bipartisan 'not in my backyard' issue, which could threaten operators' revenue needed for ongoing profitability. Her view is that the market has been resilient but has 'fires in the engine' that show up under the hood, with AI build-out concerns among them.

“At least in my world, the biggest story at play here is the AI build out, the sustainability of it, the significantly increased demand for capital, the cost of that capital.”at 7:46

Liz Ann Sonders · Charles Schwab

Small-cap stocks show sharp divergence: profitable, low-leverage, high-coverage companies are outperforming weaker ones.

Sonders says the index's resilience masks underlying stress. In small caps, such as the Russell 2000, there is a widespread split between profitable and unprofitable companies. Lower debt-to-equity companies significantly outperform higher debt-to-equity ones. High interest-coverage stocks outperform low-coverage ones. She reads this as lenders and the market discerning high-quality borrowers who still have access to capital, and where the weaknesses are.

“...we certainly see that in the small cap space within, say, an index like the Russell [2000] where you're seeing a really, really widespread open up between profitable companies and nonprofitable companies. ... Lower debt to equity companies significantly outperforming higher debt to equity.”at 8:28

Collin Martin · Charles Schwab

Credit markets call for selectivity: record issuance is happening as borrowing costs and spreads rise.

Investment-grade corporate bond issuance hit a new annual record this October, beating the 2020 high. That high came when the Fed had cut rates to zero and set up facilities to buy corporate bonds, so companies rushed to term out cheap debt. Now borrowing costs are elevated and spreads are rising. In a zero-rate world, weaker 'zombie' companies could keep borrowing cheaply, but that is no longer true. The high-yield market is largely shut after concerns from a few weeks earlier. High-quality issuers can still borrow, but low-single-A and triple-B issuers and sub-investment-grade companies face more trouble. Martin expects the credit headlines to continue and says the market cannot be painted with a broad brush.

“Now fast forward to today and we just hit a new record, and this is an environment where borrowing costs are elevated and spreads are rising, and that matters. Not every company can succeed in that environment.”at 11:52

Collin Martin · Charles Schwab

Big companies, especially in tech and the data center build-out, have strong fundamentals with healthy coverage and leverage.

Martin says large companies, especially big tech and firms in the data center build-out, have pretty strong corporate fundamentals. Interest coverage ratios are strong. Leverage, measured as debt relative to earnings, is acceptable. He still expects pockets of stress. Rising rates hit the most indebted companies and those with volatile cash flows. Overall he sees corporate fundamentals as relatively healthy, with selectivity still needed.

“On the bright side, we think that big companies and especially big companies out of tech and out of the data center build out, corporate fundamentals are pretty strong. ... Leverage is okay, debt relative to earnings.”at 13:04

Collin Martin · Charles Schwab

Labor market is steady and balanced, and slowing wage growth would help the inflation outlook.

Unemployment has held in a tight range for about 20 straight months, at 4.2% in September, and Martin expects it to stay between 4% and 4.5%. He calls that good news, since it remains low by historical standards. He expects year-over-year average hourly earnings growth of 2.9%, which would be the first reading below 3% since May 2021. Slower earnings growth would help the inflation outlook and could limit price increases if it reduces consumer demand. The JOLTS job openings-to-unemployed ratio near 1.0 suggests the labor market is relatively balanced.

“On a year over year basis, they're expected to come in at 2.9%. That would mark the first time below 3% since May 2021, and that'll be good news for the inflation outlook.”at 14:55