Federal Reserve May Act if Credit Spread Widens to 500 Basis Points

Federal Reserve Chair Jerome Powell's potential intervention in the market hinges on a critical indicator: the credit spread. If this spread widens further to 500 basis points, Powell may alter his policy stance, similar to his actions in 2018. Currently, the high-yield bond spread stands at 454 basis points, dangerously close to the 500 basis point threshold.

Recent stock market volatility has left investors anxious, but the true trigger for Powell's intervention may lie in the bond market. Analysts suggest that a widening credit spread could signal financing difficulties for businesses and a softening job market, prompting the Federal Reserve to act. Powell's firm stance last week was due to the event-driven nature of the stock market decline and positive non-farm payroll data. However, the high-yield bond spread's proximity to the danger threshold indicates a potential need for policy changes.

The bond market has not yet signaled a recession. Compared to the stock market's dramatic fluctuations, the bond market's response has been relatively muted. Yields have declined, and the yield curve has steepened in a bullish manner, but overall changes have been mild. The bond market expects the federal funds rate to fall to 3% in a year, aligning with the Federal Reserve's neutral rate target, suggesting no recessionary pricing.

Market expectations for the next year include five rate cuts, but analysts believe true recessionary rate cuts typically amount to 8-10 times. The probability of a rate cut at the May Federal Reserve meeting is only 51%, indicating that further bond market adjustment is needed to prompt Powell to change his policy stance, potentially triggering a stock market rebound.

Powell has made it clear that now is not the time to intervene in the market. This stance contrasts with his aggressive actions during the pandemic, his firm stance against inflation in 2022, and his decisive measures to save Silicon Valley Bank in 2023. Powell and his colleagues face a dilemma, as tariffs could push up prices, making it difficult for the Federal Reserve to balance market stability with inflation control. Reducing rates could stabilize the market but risk exacerbating inflation, while not reducing rates could stabilize inflation but risk further market volatility and potential economic recession.