Policy acts with lags. In the US, there are signs of slower credit growth and a softening housing market. In time, average debt service costs will rise further. How bad it gets still largely depends on inflation and the central bank reaction function. Any sign of moving to a “hold” would be well received by markets. If not, and with more hikes potentially to come, holding a constructive view on current valuations in the credit and equity markets would become more challenging.
The lags by which tighter monetary policy hits growth are unclear, and often long. It would not be unusual, by historical standards, for the worst of the impact of the tightening to still be ahead of us. There is already evidence of higher rates working. Fed data shows mortgage demand has weakened significantly. A measure of domestic lenders reporting strong demand for mortgages has dropped to its lowest level since the global financial crisis. In the same report (Senior Loan Officer Opinion Survey on Bank Lending Practices, January 2023), the numbers show a tightening of bank lending standards across the credit spectrum (to corporates and households). The credit squeeze is on and is likely to get worse.
The flow of new credit is weakening. Higher rates deter new borrowing which will have an impact on investment and consumer spending. Mortgage demand and housing activity have slowed. The volume of authorised new building permits has fallen by 30 per cent from the end-2021 peak. This suggests fewer new housing units being built, with implications for aggregate residential investment, construction employment, and housing-related demand for durable goods. It’s not a disaster. The decline in housing activity as evidenced by housing permits and starts is relatively mild in this cycle so far, compared to previous periods. But higher rates are hitting the housing market. House prices have started to roll over.
Is credit safe?
Some of the pushback to our constructive view on credit as an asset class is that spreads don’t reflect the economic risks given the impact from higher rates has not been fully felt yet. The argument is that as borrowing costs increase, there will be more stress in the corporate sector and that rating downgrades will increase — and default risk in the high-yield market will rise — and this, in turn, will lead to a widening of credit spreads from current levels. Wider credit spreads will cause negative corporate bond returns. There is a risk of spreads widening again if the risk of a slowdown materialises.
Household wealth down
Higher rates are impacting the flow of credit by raising the cost of new debt. The real damage to growth will come if rates stay high enough for long enough to impact the cost of the stock of debt. So far, this is limited. Employment is at record levels and wage growth has been strong. But consumers will start to feel the pinch if a collapse in housing demand hits house prices and leads to a decline in household wealth. Last year saw a significant decline in estimated household wealth — largely because of lower equity and bond markets — which could continue this year with markets continuing to struggle and house prices likely to fall.
Bonds getting cheaper again
Tactically, short-duration fixed income strategies remain attractive in this environment. But, as argued last week, credit looks reasonable from a longer-term view. The average price of corporate bonds is still well below par. There will be a gradual roll up in prices in the bond index which will help deliver positive returns. If the recession does come, focus will turn to rates being cut — the market still has that priced in for 2024. Any easing of monetary policy will generate some retreat from the steep inversion in yield curves that remain a feature of today’s fixed income markets. Such phases of the rate cycle are positive for bond returns.
The repricing of the near-term rate outlook has also pushed longer bond yields higher with the US Treasury 10-year benchmark above 4 per cent for the first time since November. I argued back then that, from a longer-term fundamental view, 4 per cent is fair value. Let’s see if investors do what they did last autumn and increase their exposure to bonds again. There was a window of about a month back then, when one could lock in a yield above 4 per cent. The market is giving bond investors another opportunity to do so. I don’t think it’s a bad idea to repeat. That 3.5–4 per cent (ish) range might define the bond market for some time yet.
Chris Iggo, chief investment officer, AXA Investment Managers