Our Head of Corporate Credit Research Andrew Sheets discusses why
a potential start of monetary easing by the Federal Reserve might
be a cause for concern for credit markets.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley. Today – could interest rate cuts by the Fed
unleash more corporate aggressiveness?
It's Wednesday, August 27th at 2pm in London.
Last week, the Fed chair, Jerome Powell hinted strongly that the
Central Bank was set to cut interest rates at next month's
meeting. While this outcome was the market's expectation, it was
by no means a given.
The Fed is tasked with keeping unemployment and inflation low.
The US unemployment rate is low, but inflation is not only above
the Fed's target, it's recently been trending in the wrong
direction. And to bring inflation down the Fed would typically
raise interest rates, not lower them.
But that is not what the Fed appears likely to do; based
importantly on a belief that these inflationary pressures are
more temporary, while the job market may soon weaken. It is a
tricky, unusual position for the Fed to be in, made even more
unusual by what is going on around them.
You see, the Fed tries to keep the economy in balance; neither
too hot or too cold. And in this regard, its interest rate acts a
bit like taps on a faucet. But there are other things besides
this rate that also affect the temperature of the economic water.
How easy is it to borrow money? Is the currency stronger or
weaker? Are energy prices high or low? Is the equity market
rising or falling? Collectively these measures are often referred
to as financial conditions.
And so, while it is unusual for the Federal Reserve to be
lowering interest rates while inflation is above its target and
moving higher, it's probably even more unusual for them to do so
while these other governors of economic activity, these financial
conditions are so accommodative. Equity valuations are high.
Credit spreads are tight. Energy prices are low. The US dollar is
weak. Bond yields have been going down, and the US government is
running a large deficit. These are all dynamics that tend to heat
the economy up. They are more hot water in our proverbial
sink.
Lowering interest rates could now raise that temperature
further.
For credit, this is mildly concerning, for two rather specific
reasons. Credit is currently sitting with an outstanding year.
And part of this good year has been because companies have
generally been quite conservative, with merger activity modest
and companies borrowing less than the governments against which
they are commonly measured. All this moderation is a great thing
for credit.
But the backdrop I just described would appear to offer less
moderation. If the Fed is going to add more accommodation into an
already easy set of financial conditions, how long will companies
really be able to resist the temptation to let the good times
roll? Recently merger activity has started to pick up. And
historically, this higher level of corporate aggressiveness can
be good for shareholders. But it's often more challenging to
lenders.
But it's also possible that the Fed's caution is correct. That
the US job market really is set to weaken further despite all of
these other supportive tailwinds. And if this is the case, well,
that also looks like less moderation. When the Fed has been
cutting interest rates as the labor market weakens, these have
often been some of the most challenging periods for credit, given
the risk to the overall economy.
So much now rests on the data. What the Fed does and how even new
Fed leadership next year could tip the balance. But after
significant outperformance and with signs pointing to less
moderation ahead, credit may now be set to lag its fixed income
peers.
Thank you as always for listening. If you find Thoughts to the
Market useful, let us know by leaving a review wherever you
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