Western Asset’s view has been that spread sectors will continue to generate excess returns even as the Federal Reserve (Fed) begins to raise rates. However, the last few weeks have challenged this view. Following a slightly hawkish tone from the Fed at its September meeting, US corporate and emerging market bonds have underperformed, raising the question whether recent underperformance foreshadows larger challenges for credit markets when the Fed actually begins to raise rates.
We hesitate to draw conclusions about the prospects for Fed tightening based on a few weeks of choppy markets and, for reasons outlined in this paper, continue to think financial conditions can remain accommodative amid a rise in rates. In such an environment, we would expect spread sectors to continue to outperform. The basis for this view centers on four key aspects of our thinking:
- Longer-term interest rates are likely to remain low even as the Fed raises overnight interest rates. In many ways, longer-term rates are more important than overnight rates.
- The Fed’s balance sheet and communications policies will help to offset the impact of rising overnight interest rates.
- Private credit creation in the US has accelerated recently, and easing credit standards could lead to further acceleration.
- The historical record of Fed hiking is mixed: in some instances a rise in interest rates corresponded with tighter financial conditions, but in others financial conditions remained accommodative throughout the Fed hiking cycle.
1. Longer-Term Bond Yields Are Likely to Remain Low
While the target for the Fed hikes will be overnight interest rates, in many ways longer-term interest rates are more important for the economy and markets, as the financing decisions facing corporate treasurers and prospective homebuyers are usually based on longer-term interest rates, not on overnight interest rates. Longer-term interest rates underpin equity and real estate valuations, as future earnings are often discounted by longer-term US Treasury (UST) yields. Perhaps most importantly for the current discussion, longer-term interest rates will be a key driver of total returns on fixed-income spread sectors, and as a result will be an important determinant of the demand for these assets.
Our view is that longer-term interest rates will remain relatively low even as the Fed increases overnight interest rates. This outlook reflects our expectation that inflation will remain moderate (usually higher inflation is the primary reason why longer-term interest rates would rise). Subdued global growth, combined with continued slack in certain labor markets, has reduced inflationary pressures and, in some countries, has even raised concerns about outright deflation. Central bank credibility has also helped anchor inflation expectations, thereby reducing inflation volatility and to some extent mitigating the risk of sharply higher inflation.
In addition to moderate inflation, there are reasons to expect that the real interest rate structure will remain below pre-crisis levels. Real GDP growth has slowed due to slower labor force growth, and perhaps due to a residual impact of the financial crisis on labor productivity. Moreover, “safe” assets are likely to remain in demand due to post-crisis changes in the regulatory and risk environment, which of course will mean lower bond yields.
The combination of moderate inflation and lower real interest rates is in some ways reminiscent of the environment the last time the Fed raised interest rates. The Fed began raising interest rates in June 2004 and continued until mid-2006, by which time overnight rates were 4.25 percentage points higher. Although this series of hikes had an undeniable impact on overnight interest rates, longer-term interest rates moved relatively little. In fact, during the first twelve months of the Fed’s rate hiking, 10-year and 30-year interest rates actually moved lower, a phenomenon popularly referred to as “Greenspan’s conundrum” (Exhibit 1).
Finally, the actions of other central banks will likely continue to put downward pressure on longer-term US bond yields. The European Central Bank has recently renewed its commitment to expanding its balance sheet, and we expect the Bank of Japan to continue easing policy to support Japan’s economy and push up inflation. With German and Japanese 10-year bond yields both below 1%, it will be challenging for US bond yields to move substantially higher.
The implications of longer-term bond yields remaining low are straightforward: low borrowing costs will be supportive of corporate investment and residential construction, low discount rates will provide a tailwind to equity and real estate valuations, and demand will remain elevated for fixed-income spread sectors. In this favorable environment, the impact of higher overnight rates could very well go unnoticed.
2. The Broader Set of Fed Policies Will Remain Accommodative
Recently the Fed’s reliance on “extraordinary” tools—including the size of the balance sheet and communications—has made it much more complicated to evaluate the stance of Fed policy, as the level of overnight interest rates no longer represents the full picture of Fed actions. This will likely be true for some time. To some extent, balance sheet and communications policies will help to offset the impact of raising overnight interest rates.
The most visible aspect of the Fed’s recent policies has been its purchases of Treasury and mortgage-backed securities, and the corresponding expansion of the balance sheet. This is far from over. The latest indication from the Fed is that it will continue to reinvest principal payments, which means it will continue purchasing assets on a regular basis, likely until late 2015. Even after purchases stop, the balance sheet will shrink only very slowly, as the Fed does not intend to sell assets, instead relying on maturing assets to reduce its holdings. The implication is that the Fed’s balance sheet will be extremely large for the foreseeable future (Exhibit 2).
The Fed has also increased its focus on communications as a tool to influence market participants. While these attempts have been somewhat hit-and-miss (remember when Chairman Ben Bernanke said he expected tapering would be over about the same time the unemployment rate was at 7%?), the Fed is still quite committed to guiding the market with its communications. For example, in its most recent meeting the Fed provided guidance on the anticipated start of rate hikes (“a considerable time” after October), the pace of rate hikes (“balanced”), and the level of interest rates in 2016 (“below normal”). These dovish statements are clearly intended to soften the impact of raising interest rates, and we expect such statements will remain a staple of Fed communications.
The key to anticipating how each of the Fed’s policy tools will be used is understanding the Fed’s motivation behind raising interest rates. If the Fed’s goal in raising interest rates is to slow economic activity or to change financial valuations, then it would be reasonable to expect the other “extraordinary” tools will be used in a hawkish way. If, on the other hand, the Fed’s goal is to raise overnight interest rates while leaving economic growth and financial markets broadly unchanged, then the “extraordinary” tools will likely be used in a dovish way, in order to offset the signal from raising interest rates. We suspect the latter scenario is more likely, and we expect that balance sheet and communications policies will remain accommodative during the period of rising rates.
3. Private Credit Creation Has Accelerated
Investors have become accustomed to thinking about liquidity as a function of the size of central bank balance sheets. While not a bad proxy over the past few years, this view ignores private credit creation, which has historically been the primary driver of liquidity. As the Fed starts to pull back, private credit creation will become increasingly central to the amount of liquidity available to the economy.
Bank credit creation has accelerated recently, with loans and leases held by commercial banks growing at an annual rate of 7.5% so far in 2014 (Exhibit 3a). This is substantial improvement—the pace of credit creation in 2014 is nearly three times the pace in 2013—and suggests that household deleveraging has run its course and that business sentiment may have shifted toward favoring a more expansionary approach.
Prospects for future credit growth also appear to be improving. After many years of extremely strict underwriting practices, banks appear to be loosening credit standards and widening the set of applicants they will consider for loans (Exhibit 3b). Although still in its early stages, loosening credit standards could lead to a substantial expansion of lending in coming quarters. It will be very important to watch the developments here, as the success of the Fed’s exit will depend on the ability of the private sector, and private lending in particular, to pick up the slack. The recent developments are encouraging.
4. Mixed Experiences in the Last Four Fed Hiking Cycles
Finally, we turn to the historical experience to see what we can learn from how the Fed raising rates has impacted financial markets in the past. The chart below shows the Chicago Fed’s estimate of financial conditions since 1975 (Exhibit 4). Naturally there are many ways to measure financial conditions, and not all tell the same story. The Chicago Fed’s series has the advantage of stretching over a long period as well as providing a relatively comprehensive measure that includes price and volume indicators across equity, debt, and money markets.
As is apparent from the chart, some Fed hiking cycles have coincided with substantially tighter financial conditions. For example, when Chairman Paul Volcker hiked rates in 1979, financial conditions abruptly tightened by 3 standard deviations, and when Chairman Alan Greenspan hiked in 1988 financial conditions were somewhat tighter than normal. Note that in both instances inflation was running above the Fed’s target and the Fed was hiking with the explicit intent of slowing economic activity.
However, as is also apparent from the chart, not all Fed hiking cycles have coincided with tighter financial conditions. In particular, financial conditions remained loose through both the 1994 and 2004 rate hiking cycles. These two cycles were different in that inflation was moderate at the time that hiking started. Instead of acting to intentionally cool the economy, in 1994 and 2004 the Fed hikes were pre-emptory, aiming to prevent excesses from building rather than to correct already existing excesses.
With mixed historical evidence on the impact of Fed hiking on financial conditions, we have to be cautious in drawing too strong of conclusions about what the coming cycle will look like. Nevertheless, it seems more likely to us that the coming cycle will resemble the 1994 and 2004 cycles in important ways—inflation will be moderate and the Fed will be more pre-emptory than reactionary—and as a consequence, Fed tightening may have little to no impact on financial conditions.
As we have outlined in other pieces, we think the current backdrop supports spread sectors, and we believe that moderate overweights, combined with opportunistic duration strategies, present the best chance for success. A key risk to this view is that the Fed raising interest rates disrupts financial conditions. The underperformance of spread markets following the Fed’s September meeting suggests that this concern may be on the minds of many other investors as well. While recent choppiness warrants thoughtfulness, we have not changed our view that spread sectors can outperform even as the Fed raises rates. As laid out in the four points above, the broader environment will be crucially important, and there are many reasons to think that the Fed can raise rates without materially tightening financial conditions.