Keeping the Faith For A Soft Landing

Sep 27, 2024

The recent Fed rate cut suggests confidence in a soft economic landing, as inflation shows signs of progress. Experts warn that markets must stay vigilant on incoming data, reflecting a shift in corporate credit dynamics. Unlike past cuts, this one comes amid expanding growth rather than an impending recession. The discussion also delves into how changing interest rates impact leverage loans and credit spreads, drawing comparisons to previous financial crises.

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INSIGHT

Unusual Rate Cuts

The Federal Reserve's rate cuts are unusual because they're happening during economic deceleration, not a recession.
These cuts aim to acknowledge progress on inflation, not stimulate the economy, reflecting confidence in a soft landing.

INSIGHT

Optimism on Spread Products

Morgan Stanley has been optimistic about spread products like corporate credit, despite tightening valuations.
This stance is based on the expectation of healthy credit fundamentals if the economy avoids a severe downturn.

INSIGHT

Source of Current Credit Stress

Unlike previous credit market stress periods (2008-2009, 2015-2016, 2020), the current stress is mainly due to high interest expenses.
Rate cuts could improve credit fundamentals, particularly for leverage loans, by easing pressure on interest coverage ratios.

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Credit likes moderation, and the Fed’s rate cut indicates its belief that the economy is heading for a soft landing. Our Chief Fixed Income Strategist warns that markets still need to keep an eye on incoming data.

----- Transcript -----

Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the implications of the Fed’s 50 basis points interest rate cut for corporate credit markets.

It's Friday, Sep 27th at 10 am in New York.

For credit markets, understanding why the Fed is cutting is actually very critical. Unlike typical rate cutting cycles, these cuts are coming when the economic growth is still decelerating but not falling off the cliff. Typically, rate cuts have come in when the economy is already in a recession or approaching recession. Neither is the case this time. So the US expanded by 3 per cent in the second quarter; and the third quarter, it is tracking well over 2 per cent.

So, these cuts do not aim to stimulate the economy but really to acknowledge that there’s been significant progress on inflation, and move the policy towards a much more normalized policy stance. In some way, this really reflects the Fed’s confidence in the inflation path. So that means, not cutting now would mean restraining the economy further through high real interest rates. So, this cut really reflects a growing faith by the Fed in achieving a soft landing. Also, the size of the cut, the 50 basis point cut as opposed to 25 basis points, shows the Fed’s willingness to go big in response to weaker data, especially in labor markets.

So since the beginning of the year, we have been pretty constructive on spread products across the board, particularly corporate credit and securitized credit, even though valuations have been tightening. Our stance is based on the idea that credit fundamentals will stay reasonably healthy even if economic growth decelerates, as long as it doesn’t fall off the cliff. Further, we also believe that credit fundamentals will improve with rate cuts because stress in this cycle has mainly come from higher interest expenses weighing on both corporations and households. This is in stark contrast to other recent periods of stress in credit markets – such as 2008/09 when we had the financial crisis, 2015/16 we had the challenges in the energy sector and then 2020, of course, we faced COVID.

So the best point of illustrating this would be through leveraged loans, which are floating-rate instruments. As the Fed started tightening in 2022, we saw increasing pressures on interest coverage ratios for leveraged loan borrowers. That led to a pick-up in downgrades and defaults in loans. As rate hikes ended, we started seeing stabilization of these coverage ratios, and the pace of downgrades and defaults slowed. And now, with rate cutting ahead of us and the dot plot implying 150 basis points more of cuts for the rest of this year and the next year to come, the pressure on interest coverage ratios are going to be easing, especially if the economy stays in soft landing mode.

This suggests that while spreads are today tight, the fundamentals could even improve with rate cuts – that means the spreads could remain around these levels, or even tighten a bit further. After all, if you remember the mid-1990s, which was the the last time that the Fed achieved a soft landing, investment grade corporate credit spreads were about 30 basis points tighter relative to where we are today.

That 'if' is a big if. If we are wrong on the soft landing thesis, our conviction about the spread products being valuable will prove to have been misplaced. Really the challenge with any landing is that we can’t be certain of the prospect until we actually land. Till then, we are really looking at incoming data and hypothesizing: are we heading into a soft or hard landing?

So this means incoming data pose two-sided risks to the path ahead for credit spreads. If incoming data are weak – particularly employment data are weak – it is likely that faith in this soft landing construct will dim and spreads could widen. But if they are robust, we can see spreads tightening even further from the current tight levels.

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