The Fed’s normalising of rates is not easing
Given that the US economy is healthy, we believe the market is overestimating what the Fed will do.
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- In our view, inflation is currently under control and labour demand has softened.
- The Fed agrees, and it reduced the Fed Funds rate by 50 basis points in September.
- Markets immediately priced in an aggressive and rapid decline in policy rates, which was too far, too fast, in our view.
Given that the US economy is healthy, we believe the market is overestimating what the US Federal Reserve (Fed) will do. We expect the Fed Funds rate at year-end 2025 will hover between 3.50%-4.00%.
Why is it time to normalise
Inflation has cooled. This is important to the Fed, as its primary mandate. Inflation was driven by supply-side challenges created during COVID-19, which persisted for some time. The correction in supply-side dynamics is very likely what has affected inflation. We see it as less likely that higher short-term interest rates were the principal cause of lower inflation.
Labour demand is also reduced from very high levels that could have contributed to inflation. This reduction in labour demand is the second part of the Fed’s decision tree in assessing the Fed Funds rate.
With both labour and inflation behaving, we believe it is indeed time for normalising policy.
Enough about the landing, we have landed and are at the gate
GDP growth in the US remains robust, recently revised up to 3%. There is no crisis as consumer spending and consumer performance are healthy. We do not believe we are headed to recession in the near future, and we believe the US economy has “landed”.
Are financial conditions really tight?
While most financing for the consumer and for public companies is fixed-rate in nature, the reduction in labour demand is what most point to when they say, “financial conditions have tightened”. We believe the pinch in labour demand is driven by a reduction in labour demand coming from small businesses. Small businesses are sensitive to the level of short-term interest because they generally finance at the short-term rate, plus an additional margin. The 5% increase in short-term interest rates would dramatically increase their interest expense rates. Small businesses are a substantial source of labour demand, and their confidence is lower. They are, as well, less willing to borrow to finance growth at the higher interest rates. We believe this is the channel through which the Fed has impacted financial conditions and labour markets.
Small businesses are significant contributors to US employment. Several key elements indicate declining labour demand:
- Quits rate: A drop in voluntary departures from jobs signals a lack of confidence in finding better employment.
Figure 1: Declining quits rates reveal there is less pressure for higher wages
Source: US Quits from Bloomberg, as of August 2024. Economic indicators may not be accurate measures of current market conditions and should not be solely relied upon to predict future outcomes.
- Employment Cost Index (ECI): Lower labour costs suggest that the current Fed Funds rate has resulted in less wage inflation.
Figure 2: Employment Cost Index
Source: Unit Labor Costs from Bloomberg, as of August 2024. Economic indicators may not be accurate measures of current market conditions and should not be solely relied upon to predict future outcomes.
- Job Openings: Job openings have also declined.
Figure 3: Job Openings
Source: US Job Openings from Bloomberg, as of August 2024. Economic indicators may not be accurate measures of current market conditions and should not be solely relied upon to predict future outcomes.
When investigating how the Fed's actions have affected the economy, one particularly impactful chart shows the relationship between quarterly household and nonfinancial business debt growth against GDP growth. This data reflects less willingness to take on leverage and is indicative that financial policy is tight.
Figure 4: A lower willingness to take on debt
Quarterly household and nonfinancial business debt growth as a % of GDP growth, annualized:
Source: Schroders Capital, Bloomberg, as of June 2024.
We can identify a pre-COVID-19 level of debt growth and a spike following the easing cycle, when businesses and households were eager to take on low-cost leverage. This was an expansionary phase for small business.
The decline in debt growth indicates that high interest expenses are impacting demand. For signals, a focus on small business conditions is important, as they are a key channel through which rising rates influence economic conditions.
Small businesses finance their operations with floating-rate debt, so they will experience immediate relief as soon as the Fed lowers the Fed Funds rate. This aspect deserves significant attention, especially in a landscape where inflation has been downplayed.
The disconnect between the Fed’s playbook and market expectations
There has been a noticeable disconnect between the Fed's own projections (“the Dots”) and the market's pricing of the Fed Funds rate. After the Federal Reserve’s decision to reduce the Fed Funds rate, this disconnect seemed to grow.
The implications of this rapid decline can complicate the credit landscape. The market’s reliance on the Fed to manage even the most modest of economic concerns leads to a compelling question: Is it any longer possible to experience a default cycle, and if it is not, will risk premium continue to compress?
Implications for credit investors
With an inverted yield curve, and with little term premium, we find ourselves in an environment in which the yield on short-term cash investments (money market) exceeds the yield on investment-grade corporate indices. This is very unusual. Should the yield relationship between cash and corporate credit normalise, there may be a material impact on allocations, resulting in significant changes in demand.
As allocation changes begin to flow into other areas, we may begin to see already tight risk premiums tighten even further. With risk premium today at historically low levels diversification and alternate sources of risk premium — such as inefficiency or illiquidity — may become increasingly desirable.
As we assess economic risks to the upside and downside, understanding borrower profiles, as well as collateral quality, is more crucial. Consumer debt portfolios can lean heavily toward financially insecure consumers, particularly younger or lower-income borrowers. This demographic faces significant risks, and recent higher delinquency trends are concerning.
The complexity of this environment necessitates that investors remain disciplined in their approach. Identifying inefficiencies in the market, particularly in private markets, will be key.
Strategies to pursue if you want to avoid the harsh realities
Though the US economy is generally healthy, investors are challenged by the flatness of credit curves and high valuations in many sectors. Return profiles today can be asymmetric. Reflecting on these factors suggests the benefits of managing with reduced exposure to volatility.
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