Credit likes moderation, and the Fed’s rate cut indicates its
belief that the economy is heading for a soft landing. Our Chief
Fixed Income Strategist warns that markets still need to keep an
eye on incoming data.
----- Transcript -----
Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan
Stanley’s Chief Fixed Income Strategist. Along with my colleagues
bringing you a variety of perspectives, today I'll be talking
about the implications of the Fed’s 50 basis points interest rate
cut for corporate credit markets.
It's Friday, Sep 27th at 10 am in New York.
For credit markets, understanding why the Fed is cutting is
actually very critical. Unlike typical rate cutting cycles, these
cuts are coming when the economic growth is still decelerating
but not falling off the cliff. Typically, rate cuts have come in
when the economy is already in a recession or approaching
recession. Neither is the case this time. So the US expanded
by 3 per cent in the second quarter; and the third quarter, it is
tracking well over 2 per cent.
So, these cuts do not aim to stimulate the economy but really to
acknowledge that there’s been significant progress on inflation,
and move the policy towards a much more normalized policy stance.
In some way, this really reflects the Fed’s confidence in the
inflation path. So that means, not cutting now would mean
restraining the economy further through high real interest rates.
So, this cut really reflects a growing faith by the Fed in
achieving a soft landing. Also, the size of the cut, the 50 basis
point cut as opposed to 25 basis points, shows the Fed’s
willingness to go big in response to weaker data, especially in
labor markets.
So since the beginning of the year, we have been pretty
constructive on spread products across the board, particularly
corporate credit and securitized credit, even though valuations
have been tightening. Our stance is based on the idea that credit
fundamentals will stay reasonably healthy even if economic growth
decelerates, as long as it doesn’t fall off the cliff. Further,
we also believe that credit fundamentals will improve with rate
cuts because stress in this cycle has mainly come from higher
interest expenses weighing on both corporations and households.
This is in stark contrast to other recent periods of stress in
credit markets – such as 2008/09 when we had the financial
crisis, 2015/16 we had the challenges in the energy sector and
then 2020, of course, we faced COVID.
So the best point of illustrating this would be through leveraged
loans, which are floating-rate instruments. As the Fed started
tightening in 2022, we saw increasing pressures on interest
coverage ratios for leveraged loan borrowers. That led to a
pick-up in downgrades and defaults in loans. As rate hikes ended,
we started seeing stabilization of these coverage ratios, and the
pace of downgrades and defaults slowed. And now, with rate
cutting ahead of us and the dot plot implying 150 basis points
more of cuts for the rest of this year and the next year to come,
the pressure on interest coverage ratios are going to be easing,
especially if the economy stays in soft landing mode.
This suggests that while spreads are today tight, the
fundamentals could even improve with rate cuts – that means the
spreads could remain around these levels, or even tighten a bit
further. After all, if you remember the mid-1990s, which was the
the last time that the Fed achieved a soft landing, investment
grade corporate credit spreads were about 30 basis points tighter
relative to where we are today.
That 'if' is a big if. If we are wrong on the soft landing
thesis, our conviction about the spread products being valuable
will prove to have been misplaced. Really the challenge with any
landing is that we can’t be certain of the prospect until we
actually land. Till then, we are really looking at incoming data
and hypothesizing: are we heading into a soft or hard
landing?
So this means incoming data pose two-sided risks to the path
ahead for credit spreads. If incoming data are weak –
particularly employment data are weak – it is likely that faith
in this soft landing construct will dim and spreads could widen.
But if they are robust, we can see spreads tightening even
further from the current tight levels.
Thanks for listening. If you enjoy the podcast, please leave us a
review wherever you listen and share Thoughts on the Market with
a friend or colleague today.
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