Credit strength confounds Fed watchers ahead of rate decision

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To try to control inflation, the U.S. Federal Reserve intends to tighten financial conditions across the economy, but it has yet to make much of a difference to U.S. businesses.

The additional return investors demand for risk in the U.S. investment-grade and high-yield bond markets has remained below their 20-year averages and well below levels seen during historic periods of economic stress. Borrowing remains robust, a measure of credit quality is improving at a record pace and recent earnings reports from some of the nation’s most indebted companies came in better than expected.

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How all this happened after the Fed raised its key rate at the fastest pace in four decades – and to its highest level in 22 years – is nothing short of remarkable. And this once again raises the question of whether policymakers raised interest rates until they considered a level “restrictive enough,” or whether they kept them at that level long enough.

“If you had told me two years ago that the Fed was going to raise rates this much in a short period of time, I would have said it would leave corpses littered across the corporate credit landscape,” the former Fed Governor Jeremy Stein, now Fed Managing Director. professor at Harvard University. “I really don’t have any good story for why things have been so resilient.”

Because interest rate hikes can take some time to impact the real economy, Fed officials closely monitor financial conditions to gauge in real time how their policy is working. So far, this has only affected Treasury yields – which are trading around the highest levels since the financial crisis – while stock and oil prices have remained largely resilient.

Debate on Wall Street

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The turmoil in credit conditions is currently at the heart of the debate on Wall Street. Will the Fed need to raise rates further, or can it simply hold at current levels and give its policy time to seep into the strong balance sheets of households and businesses?

“There is a lot of uncertainty around lags,” Fed Chairman Jerome Powell said at an event earlier this month. “One of the reasons we slowed down significantly this year is to give monetary policy time to act.”

Powell and his colleagues are expected to hold rates steady for a second straight meeting when they meet this week, and investors will be looking for clues as to whether another hike is still in store. Some Fed officials say they’re not done raising rates yet, given recent strong economic data: hiring remains robust, consumer spending still supports growth, and inflation is much higher to the objective.

Policymakers appear willing to wait and see if the late effects of tightening begin to dampen credit conditions and the broader economy. But the longer they keep rates steady, the more it could convince investors that they are done with it, potentially further easing financial conditions and boosting growth.

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“The bite is coming. It’s going to take a little more patience on the part of the Fed, » said Conrad DeQuadros, senior economic adviser at Brean Capital LLC, who calls for a recession next year. « Corporate spreads are extremely tight and I think that they will expand if we are right about the economic outlook in 2024. »

For the moment, credit has not weakened. The resilience of the U.S. economy — and particularly the U.S. consumer — continues to support earnings at major corporate issuers such as AT&T Inc. and Amazon.com Inc. Defaults have been widely publicized among companies that were already in debt. difficulty, and the riskiest credit companies in the triple C category are outperforming the rest of the market this year.

Corporate balance sheets are improving

“Spreads are contained because defaults are low and balance sheets are healthy,” said Tim Leary, senior portfolio manager at RBC Global Asset Management, who also highlighted the strength of the U.S. consumer and how the Credit quality, particularly in the high yield sector, has improved in recent years. the last five to ten years.

Investment-grade borrowers have issued more than $1 trillion so far this year, roughly on pace with last year, while sales of high-yield bonds have already eclipsed 2022 volume There were 12 prime issuers in the market on October 30, marking the busiest issuance day in almost two months.

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Perhaps even more surprising is the improvement in corporate balance sheets. The amount of debt reclassified from triple B — the lowest investment grade rating level — set a record this year, with $134 billion of debt increased to the single A index, according to Barclays PLC.

“We expect a continuation of the BBB to single-A transition, as inflation and monetary policy tightening have not yet managed to break consumer and, therefore, corporate balance sheets,” the strategists said directed by Dominique Toublan in a recent note. “This has delayed the widely expected slowdown in growth and provided some buoyancy to corporate profits, which should enable further improvements in the near term.”

To be sure, there are some scattered signs of emerging credit stress: a slew of regional banks collapsed earlier this year, while more recently defaults have multiplied as consumers lag behind on auto loans and the fundamentals of blue chip companies are weakening. Small businesses are increasingly pessimistic about the outlook for credit conditions, and consumer delinquencies, although low, are increasing.

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It’s a tightrope for the Fed. Officials now talk about dual risks: one being raising interest rates too high and tipping the economy into recession, or not doing enough and letting inflation persist .

“They don’t want the market to soften on them,” said Robert Tipp, chief investment strategist at PGIM Fixed Income. “You are at a good price level, maybe you still have work to do, maybe not. It takes more time to watch and wait.

Bloomberg.com

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