A little more time on Easy Street
admin | July 26, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The Fed changes the timing and magnitude of interest rate moves much more frequently than the direction of rates. Since the Fed started releasing FOMC statements in 1994, the Fed has moved rates 68 times but only changed the direction of rates eight. A Fed cut in July would mark the ninth change. The shortest interval from initial cut to eventual hike or vice versa was nine months in 1998-1999, the longest interval was 8.25 years in 2007-2015, and the average has been 2.83 years. The Fed is prone to swirl the tea leaves of inflation and employment for quite a while before changing direction. If history is a guide, the market has a little more time on Easy Street.
The Fed’s 1998 cuts may be the closest analogy to today, according to my colleague Stephen Stanley. The Fed cut by 25 bp three times that fall after Russia defaulted and Long-Term Capital Management effectively collapsed. But strong economic growth that fall and early the year after led the Fed to hike by 25 bp in June 1999. The cycle, after just nine months, had ended (Exhibit 1).
Exhibit 1: The Fed often goes for long stretches before changing policy bias
The cycle set to start on July 31 does look likely to run shorter than the 2.83-year average for Fed cycles since 1994, but I lean a little longer than nine months. Some things are different. The US economy and financial markets are more global than they were in 1998 and rates much closer to the zero lower bound. This complicates the Fed’s job. Global trade and financial flows shape US economic and financial conditions, and the lower bound raises the risk of letting inflation fall too far. The Fed may get clear signals on these issues quickly and echo its 1998 roundtrip, but slowing global growth and consequences of letting inflation fall suggest a longer cycle this time. The market can stroll along with the Fed a little longer.
The Fed’s effort to ease financial conditions should help fundamentals and technicals in fixed income. Easy conditions help borrowers, especially leveraged ones, both through falling absolute levels of rates and often, but not always, tighter spreads. Falling rates obviously lower the cost of debt, something that would have an immediate impact on borrowers with floating-rate leveraged loans and eventual impact on high yield and investment grade fixed-rate borrowers. Lower rates also encourage investors to look for yield in riskier assets, at least as long as recession does not seem imminent.
Rates in the front end of the yield curve should remain low and spreads tighten as long as the Fed maintains a clear easing bias or shifts to neutral. Market tone would likely switch if inflation expectations rise above the Fed’s 2% target and stick. That should eventually change the Fed’s bias
The biggest risk comes if growth slows below consensus. Consensus sees US growth drifting down toward 2% in 2020 with a slight rebound in 2021 and no imminent recession. A more significant slowdown without clear signals of Fed accommodation would ignite fears for leveraged loans and ‘BBB’ corporate debt.
Investors should read the Fed’s new cycle as an opportunity to extend risk at least a little beyond neutral. Low rates and easy conditions are likely with us well into next year or beyond.
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The view in rates
Shorter rates continue to price in a steadily lower path for Fed funds through 2020. As effective fed funds drop lower, longer rates should hold steady and eventually start to rise toward the Fed’s neutral level rates of around 2.5%. It’s a recipe for a steeper curve.
Interest rate volatility, at least reflected in the MOVE index, remains high relative to most levels of the last two years. Prospects of US-China trade war should keep volatility elevated, but the Fed seems inclined to counter the possible worst effects. Still, convexity still looks likely to perform well into 2020.
The view in spreads
Although spreads in credit and MBS historically have widened as the Fed starts to ease—the case in the early 2000s and in 2008—this time looks likely to be different. Recession does not look imminent, which was the case in 2001 and 2008, although market consensus sees growth today slowing into the neighborhood of 2% in 2020 before rebound slightly. Credit already seems priced for slowing growth, so lower fed funds and improving market liquidity should help credit fundamentals and improve demand for spread. Easier financial conditions should also lower the returns to liquidity and, consequently, improve relative returns on less liquid assets.
The view in credit
Slowing growth looks almost certain to catch some weaker or more leveraged credits offside. The recent abrupt repricing of a $693 million leveraged loan to Clover Technologies has spurred a flurry of due diligence on other loans or exposures that might be vulnerable. It’s early, but so far the repricing looks idiosyncratic and not a sign of a broader problem. The Fed seems sensitive to the $10 trillion in outstanding corporate debt securities and loans, equivalent to roughly 50% of US GDP. Lower rates and better liquidity should give good corporate management opportunity to strengthen balance sheets.
As for household balance sheets, the generally good news there keeps improving. The Mortgage Bankers Association index of refinancing activity lately has jumped back to levels last seen in 2016 when 10-year rates last stood at 2% or below. That activity will continue cutting household debt service, which already was at historic lows. It should also give some support to home prices, which should help homeowners continue building their equity. Of the major balance sheets in the economy—government, corporations, households and banking—households may be the strongest.