Government bond yields in the U.S. and Europe have risen sharply.
Our Head of Corporate Credit Research Andrew Sheets explains why
this surprising trend is not yet cause for concern.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Andrew Sheets, head of
Corporate Credit Research at Morgan Stanley.
With bond yields rising substantially over the last month, I’m
going to discuss why we’ve been somewhat more relaxed about this
development and what could change our mind.
It's Friday January 17th at 2pm in London.
We thought credit would have a good first half of this year as
growth held up, inflation came down, and the Federal Reserve, the
European Central Bank and the Bank of England all cut rates. That
mix looked appealing, even if corporate activity increased and
the range of longer-term economic outcomes widened with a new
U.S. administration. We forecast spreads across regions to stay
near cycle tights through the first half of this year, before a
modest softening in the second half.
Since publishing that outlook in November of last year, some of
it still feels very much intact. Growth – especially in the U.S.
– has been good. Core inflation in the U.S. and in Europe has
continued to moderate. And the Federal Reserve and the European
Central Bank did lower interest rates back in December.
But the move in government bond yields in the U.S. and Europe has
been a surprise. They've risen sharply, meaning higher borrowing
cost for governments, mortgages and companies. How much does our
story change if yields are going to be higher for longer, and if
the Fed is going to reduce interest rates less?
One way to address this debate, which we’re mindful is currently
dominating financial market headlines, is what world do these new
bond yields describe? Focusing on the U.S., we see the following
pattern.
There’s been strong U.S. data, with Morgan Stanley tracking the
U.S. economy to have grown to about 2.5 per cent in the fourth
quarter of last year. Rates are rising, and they are rising
faster than the expected inflation – a development that usually
suggests more optimism on growth. We’re seeing a larger rise in
long-term interest rates relative to shorter-term interest rates,
which often suggests more confidence that the economy will
stay stronger for longer. And we’ve seen expectations of fewer
cuts from the Federal Reserve; but, and importantly, still
expectations that they are more likely to cut rather than hike
rates over the next 12 months.
Putting all of that together, we think it’s a pattern consistent
with a bond market that thinks the U.S. economy is strong and
will remain somewhat stronger for longer, with that strength
justifying less Fed help. That interpretation could be wrong, of
course; but if it's right, it seems – in our view – fine for
credit.
What about the affordability of borrowing for companies at higher
yields? Again, we’re somewhat more sanguine. While yields have
risen a lot recently, they are still similar to their 24
month average, which has given corporate bond issuers a lot of
time to adjust. And U.S. and European companies are also carrying
historically high amounts of cash on their balance sheet,
improving their resilience.
Finally, we think that higher yields could actually improve the
supply-demand balance in corporate bond markets, as the roughly
5.5 per cent yield today on U.S. Investment Grade credit attracts
buyers, while simultaneously making bond issuers a little bit
more hesitant to borrow any more than they have to. We now prefer
the longer-term part of the Investment Grade market, which we
think could benefit most from these dynamics.
If interest rates are going to stay higher for longer, it isn’t a
great story for everyone. We think some of the lowest-rated parts
of the credit market, for example, CCC-rated issuers, are more
vulnerable; and my colleagues in the U.S. continue to hold a
cautious view on that segment from their year-ahead outlook. But
overall, for corporate credit, we think that higher yields are
manageable; and some relief this week on the back of better U.S.
inflation data is a further support.
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