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An unprecedented era of easy money came to an abrupt halt in 2022 as central banks kicked into gear to fight inflation. The US Federal Reserve raised interest rates from almost zero to 4% in just six months. Businesses, countries and consumers that had borrowed heavily when it was cheap now faced new strains, just as banks rediscovered caution in lending. This sudden tightening of credit conditions not only heightened the risks of recession and defaults, but also fueled concerns about the emergence of financial vulnerabilities previously masked by borrowing.
1. Why has money been so cheap for so long?
To prevent the global financial crisis from triggering a depression, central banks opened up their leverage, using low interest rates and other measures to try to stimulate business activity. They kept rates low for years in the face of a noticeably anemic recovery, then turned the taps back on when the pandemic hit: The Fed cut rates back to near zero, not raising them until March 2022.
2. What did this lead to?
It helped fuel a period of exceptional growth in U.S. financial markets, barring the brief, sharp pandemic slump of 2020. The U.S. stock market rose more than 580% in the wake of the financial crisis, driven by price gains and dividend payments . It also led to a massive increase in corporate and sovereign debt. From 2007 to 2020, public debt as a percentage of gross domestic product rose from 58% to 98% worldwide, and non-financial corporate debt as a percentage of GDP rose from 77% to 97%, according to data compiled by Ed Altman. Professor Emeritus of Finance at New York University’s Stern School of Business. And in search of better yields than safe debt like the government bonds on offer, investors flooded companies with cash and bought bonds from risky companies that paid higher yields while ignoring their lower credit quality. But despite rising debt, inflation has remained subdued in most advanced economies – in the US it rarely reached the Fed’s 2% target.
Inflation came with a roar in 2021 as pandemic restrictions eased while supply chains remained disrupted. In 2022, inflation, exacerbated by energy shortages and Russia’s invasion of Ukraine, reached over 9% in the US and 10% in the European region. Led by the Fed, central banks began raising interest rates at the fastest pace in over four decades. They aim to slow growth by reducing consumer demand, and in return hope prices will cool as well. Between March and November, the Fed raised the cap on the interest rate it uses to steer the economy, known as the federal funds rate, from 0.25% to 4%. Economists expect the central bank to hike interest rates to 5% by March 2023 and stay there for most of the year.
4. What does this mean for investors and markets?
After rate hikes began, the US stock market fell as much as 25% from its peak as investors braced for the slowdown that rate hikes were likely to bring. Bond prices fell the most in decades as the prospect of new issuance with higher yields made the value of existing low-yield bonds less valuable. Both investment-grade and high-yield companies are reducing their borrowing. One of the most interest-rate-sensitive areas of the US economy, the housing market, saw sales fall sharply. And newly cautious investors avoided riskiest assets like leveraged loans.
5. What does this mean for consumers and businesses?
For US companies, average yields for newly issued investment-grade bonds rose to around 6% by November and for high-yield bonds to almost 10%. Added to this are higher labor costs, particularly in sectors such as healthcare. Homebuyers are facing significantly steeper monthly payments as the 30-year fixed-rate mortgage rate topped 7%, its highest in two decades. And despite significant wage gains for US workers over the past two years, record inflation has begun to weigh on incomes. Outside the US, the Fed’s rate hikes also strengthened the dollar against other currencies, meaning dollar-denominated government and corporate bonds in emerging markets became much more expensive to redeem.
6. What are the risks associated with the changeover?
Easy access to money in the US has led to ever-increasing levels of debt among the riskiest corporate borrowers, particularly those owned by private equity firms. A commonly cited measure of leverage to earnings has increased over the past 10 years in the leveraged loan market. This means that portfolios of collateralized loan obligations, i.e. loans bundled in bonds, are also increasingly exposed to risks. Zombie firms—companies that don’t earn enough to cover their interest expenses—have become increasingly common around the world. Higher costs across the board — for capital, labor and goods — have raised expectations that the default rate will rise, particularly at heavily indebted companies.
7. Could there be another financial crisis?
Lending rules were tightened after the credit markets collapsed in 2008. But the speed at which interest rates are being raised is raising fears that something is going wrong in the financial system. In September, a hedging strategy routinely employed by UK pension funds failed as government bond yields rose faster than the funds’ models allowed. The Bank of England’s intervention was needed to calm the market turmoil.
8. Are there reasons for optimism?
Yes, on several fronts. So far, US consumer and corporate borrowers have been broadly resilient. Easy access to markets in the wake of the pandemic has allowed many companies to refinance their debt at low interest rates, eliminating the need to return to the market immediately. And pandemic stimulus payments and subsequent higher wages give households a cushion to weather some degree of economic slowdown. Overall, the proportion of risk associated with consumer bonds such as mortgages and car loans has fallen since 2006, according to a report by UBS Group AG.
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