KBRA Financial Intelligence

3 Things in Credit: Fed’s Big Move, Credit Exuberance, and Post-Cut Expectations

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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.

This was the week that had what one experienced market observer breathlessly called “the single most important [trading] session of the year!” That’s true—maybe if you’re trading the 2-Year. But for the rest of us, that tells you a lot about something that drives me crazy: the bleeding of manic, sensationalistic broadcast business reporting into fundamental research. Was this past Wednesday really the most important trading session of the year?

We know the Fed is beginning the rate cutting part of its cycle. We know that cycle has a way to go. Sure, 50 bps was a surprise to economists and investors (but not markets), judging by polls taken Wednesday prior to the release. We know the difference between 25 bps and 50 bps is, well, 25 bps—something that really isn’t all that meaningful in the scheme of things.

There really is not that much variance in how market participants view the economy today. It’s on reasonably solid footing, something Chair Powell went out of his way to remind folks of in his presser. Apart from updated projections from the Fed (which forecast no landing), there wasn’t much to “the single most important session of the year.” But you knew that.

This week, our 3 Things are:

1. Fed’s Big Move. A half point breaks convention. Is it necessary?

2. Credit Exuberance. Is relative value still strong?

3. Post-Cut Expectations. What does history tell us?

Alright, let’s dig a bit deeper.

Fed’s Big Move.

So, the rates market says it’s time to cut, early and often. Risk markets, credit, and equity, say all is well. What to make of this?

The rates market says we have a problem. Rates are punitively restrictive and, if left unattended, will throw this economy into recession. Inflation has returned to target, rates folks say, and real rates of 2.5% or so are simply too high to preserve a healthy level of economic growth. Unemployment is growing, which threatens consumer spending, which leads to slower growth, the thinking goes, and we have now entered a downward spiral.

On the other hand, risk asset perspectives note that real GDP is growing well above long-term potential, unemployment is historically low, and consumers continue to spend. Corporate profit margins are high, which is driving strong earnings growth. The equal-weighted S&P 500 is at all-time highs, the forward multiple is a full turn above the long-term average, and credit spreads are well through their long-term averages.

How do we reconcile these seemingly parallel universes?

Well, it’s really about the forward look, and the degree of confidence risk markets have in the Fed’s ability to avoid what usually happens in rate cutting cycles—a hawkish overshoot that ends in recession. The data says inflation has been tamed, so let’s restore rates, which have been clearly restrictive by design, back to neutral. The unanswered questions surround the issue of pace and magnitude of the cuts. Which really get at, just how much risk of resurgent inflation do policymakers want to take? Those who can remember all the way back to 2022 know how the ghost of Paul Volcker hangs over Chair Powell.

And yet, the FOMC made an uncharacteristically bold statement Wednesday to peel back some of that restrictiveness that is showing up in the Beige Book and as early cracks in the labor market. Keep in mind, the Fed has only deployed a 50-bp cut in times of shock, such as the GFC or COVID-19. So, this episode, while entirely justified—if we’re at full employment and inflation is tamed, 5.5% fed funds is clearly too high—is a break with convention. It is a bold stroke, done, no doubt, in response to a growing chorus of “they’re behind the curve AGAIN!”

At the end of the day, the “single most important session of the year,” the move appeased both markets, not so much by triggering a material jump in asset prices but rather an endorsement of already rich existing valuations. Unfortunately, it also gave life to some nagging questions.

Alright, on to our second Thing—Exuberant Credit Markets.

Credit markets are ripping once again. After a brief but short blowout post the July jobs report, spreads are once again well inside long-term averages, public market yields are sub-5% in investment grade, and threatening to blow through 7% in high yield, despite record-setting waves of new issue. Credit curves are flattening. BBBs to Bs are sub-200 bps, a full point inside the 293-bp long-term average. BBBs to BBs are 75 bps, the lowest since pre-pandemic and well inside its long-term average of 154 bps.

It’s, literally, all good.

Is it too good?

That simple question is a complex one. To which, I respond with a simple answer. It depends.

It depends on your investing mandate. It depends on your risk appetite. And it depends on your economic view (and maybe geopolitical view) of the future.

Here’s what we know.

Economically, we are slowing, despite what the Fed is forecasting. We’re making the assumption that the long and variable lags of monetary tightening are continuing to lean on growth. We’re making the assumption that a materially higher cost of capital is exposing deficient business models and/or inappropriate capital structures. We’re assuming that the bottom 60% of consumers, which account for 39% of spending, are seeing their ability to continue to spend at elevated levels diminishing. We’re assuming that our position in the credit cycle is more characteristic of late cycle, rather than early cycle. In other words, markets are priced for near perfection in an environment that is less than perfect.

To be clear, the relative value appeal of credit in this environment is still comparatively strong, given the richness of equities and the impact falling rates will have on cash. And with inflation now back to target and rates more in line with historical norms, the diversification and income benefits that credit provides to a multi-asset portfolio are once again evident.

It’s just that, at current valuations, it is more difficult to overweight credit for those that index. However, for buy-and-hold investors, those that manage to a yield bogey, this remains a rich environment. Structured product, private credit, off index plays make sense here. If you can absorb the illiquidity, the yield pickup remains attractive.

Alright, on to our third Thing—Post-Cut Expectations.

A few podcasts ago, we highlighted work done by Schroders on what happens to various asset classes after the Fed’s first rate cut of a cycle. The first thing to take into consideration is whether or not we are heading into (or already are in) a recession. Today, it’s pretty clear that we are not.

So, looking at rate cut cycles stretching back to 1929, in instances when the economy was not in recession, U.S. stocks on average rose a whopping 17% in the 12 months after the first rate cut. I suppose that makes sense. In any cycle, you have two forces colliding: the trends in interest rates and economic growth. If economic growth is OK and you’re just recalibrating rates lower, the net effect of that should be solidly positive for stocks, and it clearly has been. Now, it is worth noting, that today, stocks have been running up 26% in 2023 and another 20% year-to-date. So, expecting another double-digit return in 2025 is a tall order. But, safe to say, the expectation is for a reasonably sound foundation for growth—economic and earnings—to remain in place. And that is favorable for risk asset valuations.

So, what does history tell us about credit after entering a rate cut cycle? Under that same scenario (not in or about to enter a recession), corporate bonds returned 4%, presumably as price appreciation from lower rates is offset to some degree by credit spreads typically widening a touch.

As for the credit spread part of that equation, researchers at Deutsche Bank show that credit spreads for 10-Year, BBB corporates have widened on average 24 bps on a starting spread of 209 bps in the 12 months following a rate cut. That’s for data going back to 1980.

While we find all of that useful, we are also aware that so much of what happens in a year after the Fed starts to cut rates is clearly situational, something we see in the data, where the historical data set is small and where there typically is a broad range of outcomes. In our current situation, we know that visibility is relatively high, and the economic foundation is relatively strong (with healthy, in the aggregate, consumer and commercial sectors). And that makes us constructive on credit into 2025.

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

1. Fed’s Big Move. A recalibration of rates makes sense; half a point is a break from convention that introduces unnecessary questions.

2. Credit Exuberance. Attractive relative value is still strong for those that can buy structure and private credit.

3. Post-Cut Expectations. The particulars defining this cycle make us constructive on credit.

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