Could a Fed Rate Cut Affect Credit Quality?

0:00Andrew Sheets:Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. Today, could interest rate cuts by the Fed unleash more corporate aggressiveness? It's Wednesday, August 27th at 2 p.m. in London. Last week, the Fed chair, Jerome Powell, hinted strongly that the central bank was set to cut interest rates at next month's meeting. While this outcome was the market's expectation, it was by no means a given. The Fed is tasked with keeping unemployment and inflation low. The U.S. unemployment rate is low, but inflation is not only above the Fed's target, it's recently been trending in the wrong direction.

0:42Andrew Sheets:And to bring inflation down, the Fed would typically raise interest rates, not lower them. But that is not what the Fed appears likely to do, based, importantly, on a belief that these inflationary pressures are more temporary, while the job market may soon weaken. It is a tricky, unusual position for the Fed to be in, made even more unusual by what is going on around them. You see, the Fed tries to keep the economy in balance, neither too hot or too cold, and in this regard, its interest rate acts a bit like taps on a faucet. But there are other things besides this rate that also affect the temperature of the economic water.

1:21Andrew Sheets:How easy is it to borrow money? Is the currency stronger or weaker? Are energy prices high or low? Is the equity market rising or falling? Collectively, these measures are often referred to as financial conditions. And so while it is unusual for the Federal Reserve to be lowering interest rates while inflation is above its target and moving higher, it's probably even more unusual for them to do so while these other governors of economic activity, these financial conditions are so accommodative. Equity valuations are high. Credit spreads are tight. Energy prices are low, the U.S. dollar is weak, bond yields have been going down, and the U.S.

2:02Andrew Sheets:government is running a large deficit. These are all dynamics that tend to heat the economy up. They are more hot water in our proverbial sink. Lowering interest rates could now raise that temperature further. For credit, this is mildly concerning for two rather specific reasons. Credit is currently sitting with an outstanding year. And part of this good year has been because companies have generally been quite conservative, with merger activity modest and companies borrowing less than the governments against which they are commonly measured. All this moderation is a great thing for credit. But the backdrop I just described would appear to offer less moderation.

2:44Andrew Sheets:If the Fed is going to add more accommodation into an already easy set of financial conditions, how long will companies really be able to resist the temptation to let the good times roll? Recently, merger activity has started to pick up. And historically, this higher level of corporate aggressiveness can be good for shareholders, but it's often more challenging to lenders. But it's also possible that the Fed's caution is correct, that the U.S. job market really is set to weaken further, despite all of these other supportive tailwinds. And if this is the case, well, that also looks like less moderation.

3:23Andrew Sheets:When the Fed has been cutting interest rates as the labor market weakens, these have often been some of the most challenging periods for credit, given the risk to the overall economy. So much now rests on the data, what the Fed does, and how even new Fed leadership next year could tip the balance. But after significant outperformance and with signs pointing to less moderation ahead, credit may now be set to lag its fixed income peers. Thank you, as always, for listening. If you find Thoughts of the Market useful, let us know by leaving a review wherever you listen, and also tell a friend or colleague about us today.

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