Like a petulant child determined to get his way no matter how many times his parents say no, financial markets continue to rally in anticipation of impending interest rate cuts that Uncle Jerome and others from the Federal Open Market Committee (“FOMC”) Officials have signaled they are not yet ready to give. If they just hold their breath long enough, perhaps the adults in charge of monetary policy will give in to their wishes.
The tactic has arguably worked before – namely the famous taper tantrum of 2013, which delayed and reduced the Fed's withdrawal of (then) unprecedented QE stimulus, and the sharp (and nameless) market sell-off in late 2018 in response to the latter Markets fully recovered in the first few months of 2019 after the Fed backed away from further tightening and then began cutting interest rates in mid-2019. In both cases, heavy market selling expressed market displeasure with the Fed's policy actions and likely influenced to some extent the Fed's subsequent decisions. This time, the opposite is the case: Since September, markets have rallied across the board in anticipation of the Fed opening the cookie jar after nearly two years of snack withdrawals – and they are effectively daring the Fed not to disappoint.
Admittedly, it sounds strange to attribute such conscious motives to an inanimate actor like the “markets,” but there have been several instances over the past decade where it appeared as if the tail was dragging when it came to financial markets and Fed policy wag the dog. Despite its reputation (and mandate) as an independent and apolitical institution implementing monetary policy, the idea that financial market reactions have no influence on the Fed's policy decisions has become a more difficult argument since 2009. And the financial markets definitely know what they want: a perpetual sugar high.
The rally in U.S. financial markets since September reflects growing belief that the Fed's rate hikes have been delivered, inflation has been contained, a domestic recession has been averted and monetary easing is imminent. This is quite justified as the worst economic expectations for 2023 never materialized while inflation has moderated. But given various comments from FOMC officials that there is no rush to cut rates2 and that inflation remains high despite the slowdown, more evidence would be needed before the Fed concludes that its 2 percent target is achievable3, investors' interest rate expectations – implied by The Fed Funds futures curve for six rate cuts in 2024 starting in March and a Fed Funds rate of 3.75% by the end of the year appear unrealistic. So does the growing belief that the Fed will end or significantly reduce its $95 billion in monthly securities settlements by mid-year or sooner.
Furthermore, the U.S. economy's impressive ability to weather cumulative interest rate increases to date without undue negative impact on the labor market, consumer spending, or corporate profits suggests that the current interest rate regime is tolerable, even if it is anything but for businesses and consumers is considered ideal. This should remove any pressure on the Fed to reverse course prematurely, as the consequences of a resurgent inflation of reversing too soon far outweigh the risks to the economy of cutting too slowly. In fact, one could argue that the rise in markets triggered by the mere prospect of monetary easing is reason enough for the Fed to proceed slowly, otherwise it risks reigniting the speculative excesses we have seen in 2021.
Why do financial markets so stubbornly believe that aggressive quantitative easing (“QE”) is just around the corner? In a word: conditioning. The story we have increasingly seen in recent months is that an entire generation of financiers, asset managers and professional investors, including some in senior positions, have spent their entire working lives in a market environment characterized by enormous monetary incentives and a high Measure of money coined is managed interest rates. Massive quantitative easing and its ongoing impact on markets and the financial system seem completely normal because that's all they've ever experienced. The idea that the current interest rate environment is not an outlier and is far more normal compared to historical data prior to 2008 seems irrelevant to them. (The “LIBOR” The base interest rate for most loans averaged 4.75% from 2005 to 2007, while 10-year Treasury bond yields averaged 4.55% over that three-year period and BB corporate bond yields averaged 7.2%.) friendly, too when they create excessive liquidity and an abundance of moral hazard. This line of thinking is re-emerging now that this pesky inflationary episode appears to be mostly behind us.
The S&P 500 rose 24% in 2023, about half of that in the last quarter, while 10-year Treasury yields fell nearly 100 basis points in the fourth quarter of 2023 and the number of distressed corporate bonds fell 30% (illustration 1). This comes even as domestic economic growth expectations for 2024 remain subdued, the war in Ukraine enters its third year with little sign of resolution, and the Gaza conflict shows signs of regional expansion and is now impacting global shipping Red Sea impact. Regardless, this market rally has extended into the new year. This is continued optimism.
Figure 1: S&P 500 versus 10-year bonds. T-note yield and number of distressed issuers
Market survey on leveraged loans by FTI Consulting
One group that doesn't share this unbridled optimism is the leveraged lending community. We know this because we just completed our sixth yearbook Market survey for leveraged loans.4 with almost 250 answers from experienced professionals in the field of leveraged loans and workouts at major lending institutions (both banks and non-banks). Their responses reflected some cautious optimism that the coming year will show modest to moderate improvement over 2023 in most respects, but nowhere near the enthusiasm currently reflected in financial markets. Some of her more notable answers include the following:
- The risk of recession is decreasing, but remains elevated: About 42% of respondents said the likelihood of a U.S. recession in 2024 was material (34%) or likely (8%), and a recession within 12 months was significant or likely. Still, the percentage of respondents who say the chance of a recession this year is greater than negligible or small remains high given a relatively benign economic environment.
- Inflation has eased but will remain above the Fed's 2% target: Two-thirds of respondents said inflation will remain above 3% through the end of the year, with most (61%) in the 3% to 5% range. Only 25% of respondents say inflation will be below 3% by the end of the year.
- Financial markets underestimate the risk of high interest rates: A majority of respondents (46%) say that the persistence of high interest rates in 2024 is the risk most underestimated by financial markets – far more than any other risk factor, including geopolitical events and inflation.
- Leveraged lenders remain cautious: Only 21% of respondents expect conditions in the leveraged credit market to ease/ease in 2024, while only 12% expect lending standards to become more lax. Many expect leveraged loan market conditions and underwriting standards this year to remain largely the same as they were at the end of 2023.
- The loan default/training activity will continue to be at capacity: More than two-thirds of those surveyed said that the number of new loan defaults and settlements in 2024 will be slightly higher (47%) or significantly higher (24%) than in the previous year – which saw a significant increase in loan defaults and settlements. settlements came.
- No major recovery in leveraged M&A activity: 42% of respondents said the difficult macroeconomic environment will keep leveraged M&A activity subdued for another year, while another 38% expect this activity to improve slightly compared to 2023. Nonbank lenders were more likely than bank lenders to expect an increase in leveraged M&A activity this year.
- Leveraged loan returns will not change significantly this year: 47% of respondents said total returns for leveraged loans in the primary market will decrease slightly in 2024, while 45% said these returns will increase slightly; only 8% expected either a significant decline or an expansion in returns. Non-bank lenders were more likely to expect a decline in yields this year than bank lenders.
- Collection rates for defaulted senior secured debt will remain below historical standards: Approximately 58% of respondents said recovery rates for defaulted senior secured debt will remain below historical averages for the foreseeable future due to high deal leverage and heavy reliance on senior secured debt in recent years, while 23% said , it is premature to assume such a trend The weak recovery will continue, and 19% said that as the economy recovers, recovery rates will return to historical norms.
The general responses from lenders in our survey do not match the optimistic expectations of financial markets. Some respondents may have been hesitant to openly express their optimism for the coming year after an extremely challenging and turbulent year for leveraged credit markets. However, it is far more likely that the facts on the ground currently do not support the wide-eyed optimism inherent in financial markets' expectations, unless the Fed soon deviates from its own script and starts feeding the beast again. We tend to take them at their word.
Restructuring activity has slowed since November and is off to a slow start in 2024 as more leveraged credit issuance in recent months has extended the lifeline of some issuers. However, our survey of leveraged lenders shows that they are overwhelmingly cautious about the outlook for the year ahead. In fact, the entire conversation boils down to this: Who are you going to believe?
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