Contrary to intuition, a gradual pace of Fed rate cuts is often preferable for credit markets. It signals a stable economy, whereas aggressive cuts typically coincide with significant economic deterioration, which hurts credit performance despite the monetary stimulus.
Related Insights
While lower rates seem beneficial for leveraged companies, the context is critical. The Federal Reserve typically cuts rates in response to a weakening economy. This economic downturn usually harms issuer fundamentals more than the lower borrowing costs can help, making rate-cutting cycles a net negative for high-yield credit.
A common misconception is that Fed rate cuts lower all borrowing costs. However, aggressive short-term cuts can signal future inflation, causing the 10-year Treasury yield to rise. This increases long-term rates for mortgages and corporate debt, counteracting the intended economic stimulus.
While political pressure on the Federal Reserve is notable, the central bank's shift towards rate cuts is grounded in economic data. Decelerating employment and signs of increasing labor market slack provide a solid, data-driven justification for their policy recalibration, independent of political influence.
The Federal Reserve’s recent policy shift is not a full-blown move to an expansionary stance. It's a 'recalibration' away from a restrictive policy focused solely on inflation toward a more neutral one that equally weighs the risks to both inflation and the labor market.
When questioned on the effectiveness of one 25bps cut for the labor market, Fed Chair Powell replied it would do "nothing" but that "it's the path that matters." This statement implies the Fed is not making a one-off adjustment but beginning a deliberate easing cycle.
In shallow easing cycles, historical data shows Treasury yields don't bottom on the day of the final rate cut. Instead, they typically hit their low point one to two months prior, signaling a rebound even as the Fed completes its easing actions.
The Federal Reserve's anticipated rate cuts are not a signal of an aggressive easing cycle but a move towards a neutral policy stance. The primary impact will be modest relief in interest-sensitive areas like housing, rather than sparking a broad consumer spending surge.
Despite low unemployment and high inflation, the Fed is cutting rates to preempt a potential job market slowdown. This "run hot" strategy could accelerate an economy already showing signs of heat from high valuations and low credit spreads, creating significant risk.
The FOMC's recent rate cut marks the end of preemptive, "risk management" cuts designed to insure against potential future risks. Future policy changes will now be strictly reactive, depending on incoming economic data. This is a critical shift in the Fed's reaction function that changes the calculus for predicting future moves.
The reason for the Fed's rate cuts is critical. A "good" cycle with firm growth and declining inflation leads to strong commodity returns. Conversely, a "bad" cycle with decelerating growth and sticky inflation results in negative returns, making the 'why' more important than the 'what'.