KBRA Financial Intelligence

3 Things in Credit: 10-Year Blues, Uncertainty, and Credit Card Defaults

Listen to Van Hesser's insights on: Spotify | Apple | YouTube Music

Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

Happy New Year! I know I’m bumping up against Larry David’s statute of limitation on that greeting, but I’ve taken a couple of weeks off, so I didn’t want you to think I forgot about you.

The new year brings a fresh new “Top Risks 2025” from one of our favorite sources, Ian Bremmer and Cliff Kupchan at Eurasia Group. Make sure you have a look. I’ll give you two sentences from their intro as a tease, and I quote: “[We are] in the midst of unprecedented expansion and growth [with] staggering opportunities after tens of thousands of years of stagnation. We’re entering a uniquely dangerous period of world history on par with the 1930s and the early Cold War.” OK, then.

This week, our 3 Things are:

1. 10-year blues. We assess the impact of an unwelcome spike.

2. Uncertainty. It’s returned—what does that mean for valuations?

3. Credit card default rates. Just how worrisome?

Alright, let’s dig a bit deeper.

10-year blues.

At the risk of stating the obvious, credit markets work best when investors and issuers are lined up on risk, credit spread, and the risk-free rate. Volatility, born of uncertainty and a lack of consensus, around either one of those can create an air pocket where transactions don’t happen, until stability returns. Needless to say, over the past 18 months, the risk-free part of the credit equation has become unmoored. Over the past four months, just when the Fed started cutting rates, the 10-year spiked 106 bps. Wait, what?!

Our good friends over at Deutsche Bank remind us, for those keeping score, that over the past 14 Fed easing cycles, dating back to 1966, this one, thus far, has resulted in the 10-year’s second-worst performance.

From our perspective, this feels like higher-for-longer, part II, triggered by two catalysts: (1) Trump 47’s policy leanings, much of which look inflationary, and (2) Fed Chair Powell’s unusually candid characterization of the central bank’s inflation forecast at the December FOMC presser as having “kind of fallen apart.” A holiday lump of coal if there ever was one.

That said, let me push back on the now tedious criticism of this Fed and its oft-derided “data dependency” and communication strategy. I’m not sure what the alternative to “data dependency” is, but I’m pretty sure it pales in comparison. And stop hanging on every word uttered by Fed talking heads. Get the gist and stop parsing language. It’s not hard.

In any event, volatility of the 10-year is much more a function of uncertainty around Trump 47’s policies and the effects of the massive ballooning of U.S. sovereign debt, the latter the result of the decision to triage the GFC and COVID with, yes, debt. The buildup, which has seen debt (held by the public) to GDP rise from 40% to 100%, has sustained economic growth right through today’s surprisingly strong, above potential output.

The question, of course, is just how sustainable is this? Will the sovereign funding burden crowd out private capital as BlackRock CEO Larry Fink says? Will bond vigilantes stage a buyers’ strike? Will Trump 47 make it worse? How stable is investor demand?

All good and relevant questions. The good news, if you want to label it that way, is that rates self-correct. Higher-for-longer means 24% credit card rates, 7+% mortgages, 12% middle market loans. Interest-sensitive sectors slow down. Slowdown creates slack in the labor market. Rates eventually retreat. Slowdown brings us back to normal. Normal is 1.8% real growth and 2%-2.5% inflation. Layer on a term premium, and you get a 10-year between 4.5% and 5%. Historically, that’s been constructive to economic growth. Two major shocks and massive QE got us well off normal over the past 15 years. The transition back to normal has not been a smooth one. Don’t unfasten that seatbelt just yet.

Alright on to our second Thing—The return of uncertainty.

Despite many reports to the contrary, we think back on 2024 as a period of relative certainty. Inflation was coming down convincingly, economic growth was solidly positive, earnings growth had bounced back smartly from its “recession” back in 2023, and the labor market had remained quite healthy through it all. Really the only point of uncertainty was around geopolitical events.

All of that, of course, was constructive to risk markets, which became historically favorable: very high equity valuations and very tight credit spreads. Essentially priced for perfection.

Some of this changed last October, when polls revealed Trump pulling ahead in key swing states. Stocks moved higher still, and rates bounced, reflecting increased likelihood that two things were likely to change: increased animal spirits and deregulation, and inflationary pressure.

More change happened in December, when, at the FOMC disclosure, Fed Chair Powell said the aforementioned reveal that the central bank had lost confidence in its inflation model. The 10-year hasn’t stopped rising since.

So, today, we have uncertainty around inflation and the risk-free rate. That creates uncertainty around economic and earnings growth, and that creates pressure on risk valuations. Imperfection in a world where risk had been priced for perfection.

But let’s keep all of this in perspective. A 5% 10-year is not overly restrictive. The average 10-year in the 20 years prior to the GFC (so, prior to massive central bank intervention and their zero interest rate policies) was 6%. As mentioned, rates have a way of self-correcting, so, we wouldn’t expect rates to remain in the 5s as the economy retraces back to normal. We still do expect inflation to be well behaved, as deficit-fueled growth is on the wane, and as the countervailing forces of automation and globalization remain as cooling offsets. In other words, our model has not fallen apart.

Still, there is more uncertainty today than a year ago. Trump 47 remains a very real wild card. We’ll have to wait and see just how good guardrails—bond vigilantes, the stock market (Trump’s north star) and incoming Treasury Secretary Bessent—will be. Still, look for greater uncertainty to lean on historically strong risk market valuations over the near term.

Alright, on to our third Thing—Credit card defaults.

Regular listeners know that we have long watched, with wonder, developments in credit card losses. We first highlighted curiosities in card underwriting in the pandemic when Rich Fairbank, CEO of Capital One, warned that noteworthy risk was building in the card space resulting from card lenders lending on credit scores inflated unsustainably by stimulus payments. Sure enough, roll forward and we now have card defaults hitting the highest level since 2010. Bear in mind, unemployment in 2010 was 9.6% versus 4.2% today.

The good news, we’ve pointed out, is that card (and other) consumer lenders began tightening their credit boxes back in 2022 in order to contain the damage. Today, we’re seeing positive developments in early-stage warnings, delinquencies.

The Kansas City Fed published a report in December with a rather upbeat title, “Consumer Credit Cards Show Few Signs of Financial Stress.” The piece notes that despite rate hikes, “the consumer credit market shows little sign of financial stress as of September 2024. While credit card delinquency rates have increased among subprime borrowers, internal bank assessments suggest that subprime default risks remain historically low.”

The bank notes that card delinquencies for prime quality borrowers have not risen since the Fed began hiking rates back in 2022. And the prime cohort makes up 77% of the consumer credit market, according to the authors. Delinquency rates among subprime borrowers, however, have bumped up 5.6 percentage points over the same period, and currently sit at a cyclical high at more than 20%. The piece also notes that revolving balances for both prime and subprime borrowers remain below their pre-pandemic levels, another sign that consumers are not recklessly borrowing, although lenders tightening their credit boxes no doubt have kept a lid on subprime balance growth.

The piece also notes that internal bank assessments suggest that the probability of default among subprime borrowers remains at historically low levels, something that surely speaks to the healthy labor market.

We often reference our “Two Economies” theme, where wealthier households are financially sound and continue to spend with abandon, unlike less wealthy households, which are more stressed. Wealthier households, of course, dominate the aggregate data, be it in the consumption or borrowing dynamics. But don’t lose sight of less wealthy households. Their impact on spending is not immaterial and tighter credit in the subprime space will lean on overall growth, and we expect that to become more and more apparent as we roll through 2025.

So, there you have it, 3 Things in Credit:

1. 10-year blues. Spikes are disrupting, but the absolute level is not worrisome.

2. Uncertainty. Imperfection in markets price for perfection.

3. Credit card default rates. Under control, but at a cost to growth.

As always, thanks for joining. We’ll see you next week.