The correlation between US stocks and bonds is gradually breaking down! The higher the interest rates, the more active the credit market becomes

Zhitong Finance learned that after inflation data showed a general cooling of US price pressures, the credit market breathed a sigh of relief, but the weakening economy brought new risks to corporate debt. Following lower-than-expected inflation in June, the risk measure for the high-yield credit market fell to its lowest level since March. However, this optimism may mask the risks of credit rating and default rates rising if the Federal Reserve fails to achieve a soft landing, the economy cools excessively.

Morgan Stanley strategist Vishwas Patkar said in a phone interview: "In this post-pandemic period, we are seeing a series of different variables showing weakness at the same time. We do not want to see the economy slow down further from now. If growth becomes too weak, you will start worrying about fundamentals, defaults, and downgrades."

For those bearish on the US economy, there are signs that the economy is showing weakness. Hiring and wage growth slowed in June, the unemployment rate rose to its highest level since the end of 2021, and service sector activity contracted at the fastest pace in four years. Economic forecasters unanimously believe that there is a 30% chance of a recession in the next 12 months.

Gregory Daco, Chief Economist at EY, said: "Inflation is no longer the only risk we face. With the labor market seemingly fully balanced, maintaining overly restrictive monetary policy could lead to unwanted weakness in job growth and the economy."

So far, credit investors have ignored these risks and have heavily invested in bonds to achieve the highest yields in 10 years. Due to continued demand outstripping supply, the risk premiums in both the high-yield bond and investment-grade bond markets are tight. According to data compiled by LSEG Lipper, fund managers are also moving up the risk curve, withdrawing funds from blue-chip stock funds and adding $675.5 million in investments to junk funds.

However, Priya Misra, portfolio manager at JPMorgan Asset Management, said over the phone: "The correlation between the stock market and credit is breaking down as long-term higher rates are detrimental to a large part of the stock market but overall beneficial to credit as investors chase yield." Patkar stated that Morgan Stanley remains optimistic about credit, despite downside risks, and that the worsening of the US economic recession is not its fundamental prediction. After strong credit growth this year, other investors are gradually withdrawing from the US. For example, a report released last Friday by asset management company Amundi SA showed that the company currently favors Europe in terms of valuation.

For some investors, a series of recent US economic data has refocused attention on economic growth prospects, which is welcomed. Jeff Klingelhofer, Co-Head of Investments at Thornburg Investment Management, commented on the latest employment and inflation data: "The major milestones of the Federal Reserve are behind us. We can finally break free from endless discussions about the Fed and focus on what really matters: the underlying economy."