What does recent central bank policy mean for credit markets?

Hi, I’m James Briggs, Corporate Credit Portfolio Manager at Janus Henderson.

The Fed kept interest rates on hold, as expected, but delivered a hawkish message, with guidance retained that one more rate hike is still to be expected in the closing months of the year.

The Summary of Economic Projections was updated to reflect a more resilient economy than anticipated, with labour markets and consumer spending in particular having surprised to the upside in recent months. The committee has embraced recent data to extrapolate a much more optimistic soft landing scenario for 2024 and 2025, expecting inflation to continue to moderate towards target without a material uptick in the unemployment rate. While these forecast revisions are, to some extent, a realistic mark-to-market exercise following recent data, the revisions in the outer years appear to be less supported by previous cycles. Chair Powell acknowledged that the uncertainty around these forecasts remains high and played down their importance in driving policy, continuing to highlight that Fed remains data dependent and that the totality of the incoming data will key to driving interest rates going forward.

In our view the chance of an additional rate hike at either the November or December meeting remains finely balanced, but we continue to anticipate that no further increases will be required and that we have reached the terminal rate for this cycle. The statement reflected the better-than-expected growth since the June forecasts but, importantly, didn’t reference that inflation has also surprised positively. Looking forward the laundry list of potential risks to growth has increased, with a potential government shutdown and escalating labour disputes adding to the resumption of student loan repayments as excess savings run down. Recent trends suggest that the economy may be strong enough to withstand these headwinds, and the Fed has tried to buy some time to assess the incoming data without messaging that rates have peaked or unwinding the restrictive policy that they’ve put in place over the last 18 months.

This feels like a sensible approach of pausing the hiking cycle, while messaging a higher-for-longer policy that is laser focused on the upside risks to inflation provides flexibility to adapt. With upcoming GDP revisions and base effects continuing to normalise we think the need for hawkish messaging may be needed less in the meetings ahead.

This, of course, contrasts with what we saw from the ECB last week, where interest rates were raised by 25 basis points to 4% but the commentary guided that no further increases would be required. Again, the ECB were keen to stress data dependence and retain the optionality if inflation doesn’t continue to come down. But they also said that they now believe maintaining rates at current levels would likely be sufficient to return inflation to target, emphasising the weight of these comments in the press conference. It feels like an easier statement to make that we are likely at the peak for interest rates in the Eurozone than in the US. But for both geographies the central banks are seeking to move the discussion away from how high interest rates need to go, to how long they need to stay at restrictive levels.

The markets have reacted fairly negatively to the Fed meeting with bond yields moving higher and risk assets moving lower. Short-dated treasuries now have the highest yields we have seen since 2006 and yields on short dated corporate bonds have repriced favourably in response. In terms of the outlook from here we’ve said for some time that buying the market at the time of the last rate hike tends to lead to strong risk-adjusted returns. So from an asset allocation standpoint, assuming we don’t see a reversal in recent inflation trends, now could be a good time to capture the high quality income available in investment grade credit markets.

In terms of our economic outlook, the recent FOMC meeting delivered no surprises and therefore doesn’t really change our thinking. We have recently seen a slightly easier path to a soft landing in the US, mainly as a result of higher budget deficits than we were expecting this year leading to significantly stronger infrastructure spending. Having said that the changes to the projections to reflect better growth and employment dynamics without any corresponding inflation impact seems optimistic in light of some of the potential challenges.

Despite more supportive comments from the ECB we continue to be cautious on the outlook for growth in Europe and in Asia.

Our Fixed Maturity Bond model portfolio was already highly diversified, both from a sector and a geographic standpoint. So we aren’t expecting to make significant changes from these meetings, but we might tilt portfolios away a little bit in cyclical sectors in Europe towards US companies.

We have also seen the financial sector recover quicker than we anticipated from the bank failures earlier in the year, and it does now seem that the firebreaks that regulators put in place in order to avoid systemic risk and contagion have been successful. While we remain concerned about the outlook for some of the smaller regional banks, particularly around their commercial real estate exposure, it does seem that the outlook for some of the globally, systemically important banks, those multinational majors, is better than we feared it might be.

So again, there might be some opportunities to tilt the portfolio a little bit in favour of financials relative to non-financials. Broadly, we agree with Chair Powell that the outlook for the economy remains uncertain, but we do think investment grade credit markets currently give a great opportunity to capture enhanced yields without taking a huge amount of fundamental credit risk. With a fixed maturity bond portfolio, we’ve built a highly diversified portfolio of high quality, defensive credit that we think stands a good chance of capturing those yields in good times as well as bad.

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