Correlations Between Credit and Equities Are Breaking Down

Credit markets are breathing a sigh of relief after inflation data showed price pressures are cooling broadly, but a weakening economy poses fresh risks to corporate debt.

A perceived gauge of risk in the high-yield credit market eased to the lowest since March following cooler-than-expected inflation in June. But the optimism may be masking risks that would materialize if the Federal Reserve doesn’t manage to pull off a soft landing and the economy cools too much, potentially pushing credit downgrade and default rates higher.

“For the first time in this post-Covid cycle we are seeing concurrent softness across a bunch of different variables,” Vishwas Patkar, a strategist at Morgan Stanley, said in a phone interview. “We don’t want to see the economy slow too much further from here. If growth is too weak, you start to worry about fundamentals, defaults and downgrades.”