Q4 Credit Research Outlook Time to Ease

The US Federal Reserve turbo-charged the global easing cycle that had begun with rate cuts from other major global central banks. We examine what this cycle may mean for economies and the major financial institutions that are our major investment counterparties.

Over the past quarter, the global monetary policy easing cycle has become more synchronized. The Federal Reserve's recent decision to cut interest rates by 50 bps brings it in line with several central banks for the world’s major economies, including the European Union, the UK, Canada, New Zealand, Denmark, Switzerland, and China. We don’t consider this more synchronized easing cycle as a “gamechanger” for economies, or for the credit profiles for major global banks and financial institutions.

In our view, the central banks’ pivot to policy easing has been justified by the distinct weakening of economic data over the past few quarters. Using the US as an example, we’d point to a weakening labor market, with the jobless rate rising 80bps from the lows, as well as a material increase in credit card delinquencies and small business bankruptcies. Still, unlike in many past US easing cycles, rate cuts are coming while economic growth is still relatively healthy, even if decelerating. The US jobless rate is still historically low, and household incomes are still rising, fueling consumption. US consumers also have the tailwind of a wealth effect, as household wealth is up +$40 trillion since the start of COVID.¹ With the path of inflation distinctly more benign, recent rate cuts in the US, and elsewhere, represent central banks’ attempts to get ahead of the negative momentum and choke off recessionary risks.

As our readers know, systemically important banks in the largest developed economies represent the most significant part of our investment universe. A standard interpretation of the “bank business model” would suggest that interest rate cuts are negative for banks’ net interest income, but good for asset quality.

We will borrow a Moody’s framework to demonstrate several aspects of this dynamic during typical rate cut cycles:

While we directionally agree with the framework of this type of analysis, we also recognize that the path forward will be much more nuanced. For example, while deposit costs will reprice downward more slowly than loan yields in the near term, constraining net interest income, many banks have added interest rate hedges, shortened certificate of deposit (CD) maturities, and adjusted their asset mixes more toward fixed-rate assets, in anticipation of the rate cuts. This should blunt some of the negative impacts on net interest income. Additional fee opportunities from higher capital markets volumes, and more robust loan origination pipelines, should also benefit profitability. With regards to asset quality, lower rates make business and consumer debt payments more affordable for borrowers with floating-rate loans, as well as making refinancing debt more affordable. Still, it will take time, and perhaps certainty that additional rate cuts are forthcoming, to materially improve the outlook for some of the more challenged asset classes, such as commercial real estate (CRE). Indeed, the medium term path of long term rates (which is still uncertain) will be a bigger determinant of the asset quality for certain sectors.

Lower interest rates should improve the outlook for parts of the broader credit markets that are most leveraged, and most negatively impacted by higher interest expenses, such as leveraged loans and non-investment grade rated corporations. Indeed, the easing of financial conditions in anticipation of rate cuts have paved the way for robust debt issuance in fixed-income capital markets in 2024, including for non-investment grade debt issuers. During the policy tightening cycle, we regularly heard concerns about impending maturity walls in leveraged credit and the risks that they posed, but with the ramp-up of refinancing activity in 2024, maturity walls have continued to extend. In the US market, HY issuers have $61 billion in near-term maturities by end-2025, down by $67 billion or 53% since the start of the year, due to refinancing. Similarly, leveraged loan borrowers have taken advantage of the market rally to extend maturity runways through refinancing.²

While there are plenty of elements in place that could enable central banks to engineer soft landings, there is still risk of further economic slowdowns, and even recessions, across developed market economies. There will be continuous debate as to whether central banks “are ahead of the curve” with regards to easing financial conditions enough to help reverse the downward momentum in many economies. In addition to the aforementioned weaking of economic data, there has also been slowdown in net credit creation (which excludes refinancing) across all forms of corporate credit, including IG, HY, syndicated loans, private credit, and bank-held loans. In fact, the current pace of net credit creation is slower than what was observed throughout the 2001-2002 recession.³ The economic impact of this slowdown could become more entrenched and lead to a further decrease in the pace of investment and hiring in many economies, in the absence of additional policy easing. We’ve heard these sentiments from many business leaders:

“What we’re hearing from clients is that they need to see … somewhere between 75 or 100 basis points of rate cuts before they'll go from being cautious on investing in the business to being even more aggressive," Fifth Third (FITB) CEO Tim Spence told Yahoo Finance in a recent interview (8/4/24).

Of course, central banks aren’t cutting interest rates in a vacuum, so the effectiveness of monetary policy in spurring economic growth will also depend on many factors outside their control. As we noted in our previous Credit Research Outlook , geopolitical risks could materially impact economies, and potentially mitigate the effectiveness of monetary policy stimulus. At the immediate forefront is the US Presidential election, the results of which could possibly lead to trade tariffs and immigration curbs that have “stagflationary” impacts on the US and global economies. Further, there is the likelihood that US budget deficits could balloon further, no matter which candidate wins the election, potentially shining a spotlight on public debt burdens. The key lesson from the Truss debacle in the UK in 2022 is that the attitude and tone of policymakers is important for government bond markets. In addition to the forthcoming election in the US, national elections are due next year in Germany. Meanwhile, France’s new government may struggle to pass a budget which delivers the fiscal tightening needed to put its public debt on a more sustainable path. There is a rolling “tail risk”, in our view that global bond markets could turn volatile, very quickly, and further jeopardize the central banks’ ability to deliver a soft landing.

The credit markets- even in the short end- continue to be “priced for perfection” in our view. Risk-adjusted return opportunities favor a conservative approach for credit investing. In managing the credit decisions for our global cash investment portfolios during this volatile period, our credit research team continues to plan for recessionary conditions. We believe that this conservative approach best serves our institutional clients that are invested in these strategies.

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