by Chris Black
A sharp decline in interest rates in benign economic conditions opens up the possibility of a re-acceleration in economic activity that would limit the number of future Fed cuts.
One mechanism through which higher interest rates slow the economy is through reduced lending, where higher rates discourage borrowers and prompt lenders to retrench on credit concerns.
Despite an aggressive rise in rates, a wide range of measures on credit quality show only modest deterioration to levels prevailing before 2020.
At the same time, households and corporates remain financially sound.
This suggests that a decline in rates could potentially lead to a re-acceleration of credit growth that rekindles inflationary pressures.
A wide range of measures show that the Fed aggressively raising interest rates has not had a significant impact on credit quality.
The primary lenders in the U.S. are banks and institutional investors, who lend by buying corporate bonds.
Data from the FDIC (https://www.fdic.gov/news/speeches/2023/spnov2923.html) show a recent rise in the rate of noncurrent and charged off bank loans, but only to rates prevailing before 2020.
Similarly, corporate credit spreads on both high yield (https://fred.stlouisfed.org/series/BAMLH0A0HYM2) and investment grade bonds (https://fred.stlouisfed.org/series/BAMLC0A4CBBB) remain within historical ranges.
In addition, chapter 11 bankruptcy filing rates remain around its 10 year trend after rising from historical lows.
Note that default rates also remain modest (https://www.proskauer.com/release/proskauers-q3-2023-private-credit-default-index-highlights-the-resilience-of-private-credit-in-a-turbulent-economy) in private credit, a relatively small but rapidly growing class of lenders.
The overall picture suggests some deterioration in credit quality that is better characterized as normalization.
A primary reason for the benign credit conditions is that most borrowers are simply insulated from the rise in interest rates.
A recent study from the BIS (https://www.bis.org/publ/qtrpdf/r_qt2312.pdf) found that U.S. non-financial firms have heavily staggered the maturity profile of their debt where most debt is due after 2025.
Corporate bonds tend to be fixed rate (https://www.federalreserve.gov/econres/notes/feds-notes/potential-increase-in-corporate-debt-interest-rate-payments-from-changes-in-the-federal-funds-rate-20171115.html) so many issuers remain locked in historically low pandemic era rates.
However, loans tend to be floating rate so some borrowers are making higher interest rate payments.
U.S. households are even more insulated from the rise in interest rates as their largest liability tends to be a 30 year fixed rate mortgage.
Research from data firm Redfin (https://www.redfin.com/news/high-mortgage-rates-lock-in-homeowners-2023/) suggests that most U.S. mortgage holders are locked in at rates below 4%.
As borrowers have been able to handle higher interest rates, lenders have not been exposed to significant credit losses.
This means lenders are in a position to lend should declining interest rates re-kindle loan demand.
The strong financial condition of households and corporations indicate they would be able to increase leverage should interest rates decline to attractive levels.
Both household and corporate balance sheets remain historically strong.
Household net worth surged in 2020 and remained around historical highs (https://fred.stlouisfed.org/series/BOGZ1FL192090005Q) at the end of September.
The recent rally in financial assets and continued rise in home prices (https://www.corelogic.com/intelligence/us-corelogic-sampp-case-shiller-index-annual-growth-moves-higher-september/) suggests that household net worth is currently at all time highs.
A similar story can be seen in corporate net worth (https://fred.stlouisfed.org/series/TNWMVBSNNCB), which also remains around all times highs due to the appreciation in real estate and financial assets.
A high net worth suggests that households and corporations have significant amounts of collateral to pledge against potential loans.
The income of households and corporations also appear to be strong enough support further borrowing. Although interest rates have risen, income growth has also picked up.
Overall income as measured by nominal GDP is growing at a historically high 6% (https://fred.stlouisfed.org/series/GDP) with wages also growing at a historically high 4.3% (https://www.bls.gov/eci/home.htm).
This is reflected in household debt servicing ratios (https://fred.stlouisfed.org/series/TDSP), which remain low despite the rise in interest rates.
The persistently solid employment data suggest that the high rate of wage growth can continue.
While the growth rate of corporate profits has slowed, the level of corporate profits (https://fred.stlouisfed.org/series/CP) as well as corporate margins (https://www.bloomberg.com/news/articles/2023-08-30/us-corporate-profits-are-rising-again-as-recession-fear-fades) remain high.
The overall balance sheet and income strength of households and corporates suggest that a decline of interest rates may entice additional borrowing.
Rate cuts under benign economic conditions could lead to a resumption in credit growth that rekindles inflationary pressures.
The relatively low rates of 2022 ignited a tremendous credit boom (https://fedguy.com/credit-boom/) that contributed to the sustained growth and inflation we have experienced. FDIC data show that the rapid rise in interest rates markedly slowed bank loan growth, but that could easily reverse with a decline in rates.
The Fed is expected to lower interest rates due to steady disinflation, but the market’s aggressive pricing of rate cuts reduces the probability of deep cuts.
This struggle is likely to continue throughout the next year such that the almost 5 cuts in market pricing (https://www.chathamfinancial.com/technology/us-forward-curves) will turn out to be much too high.
The paradox is that a high number of expected rate cuts stimulates economic activity and ultimately leads to fewer actual cuts.