Schroders expects the US Federal Reserve (US Fed) funds rate to hover between 3.5% and 4% at the end of 2025. The current Fed funds rate as at Nov 1 is at 4.83%.
Given that the US economy is healthy, Michelle Russell-Dowe, co-head of private debt and credit alternatives at Schroders, believes that the market is overestimating what the US Fed will do.
In her view, inflation is “under control” and labour demand has “softened”, supported by the Fed’s 50 basis points (bps) cut in September.
“Markets immediately priced in an aggressive and rapid decline in policy rates, which was too far, too fast, in our view,” Russell-Dowe adds.
Labour demand
Russell-Dowe notes that it is time to normalise as there has been a correction in supply-side challenges and a reduction in labour demand, areas that have contributed to inflation.
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She believes that the pinch in labour demand is driven by a reduction in labour demand from small businesses that are sensitive to the level of short-term interest rate because they typically finance at the short-term rate, plus an additional margin.
Small businesses are a substantial source of labour demand. Their confidence is lower and they are less willing to borrow to finance growth at higher interest rates.
As such, Russell-Dowe is of the opinion that this is the channel the Fed has used to impact financial conditions and labour markets.
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There has been a pre-Covid level of debt growth and a spike following the easing cycle, with businesses and households eager to take on low-cost leverage, representing an expansionary period for small businesses.
“The decline in debt growth indicates that high-interest expenses are impacting demand. For signals, a focus on small business conditions is important, as they are a key channel through which rising rates influence economic conditions,” Russell-Dowe notes.
GDP growth
Further to the report, it is noted that GDP growth in the US remains robust and was recently revised up to 3%, with consumer spending and consumer performance remaining at healthy levels.
“We do not believe we are headed to recession in the near future, and we believe the US economy has “landed”,” Russell-Dowe states.
Implication for credit investors
Russell-Dowe has also identified a “noticeable” disconnect between the Fed’s projections and the market’s pricing of the Fed funds rate, with a growing disconnect following the Fed’s decision to reduce the Fed fund rates.
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This has the potential to complicate the credit landscape.
With an inverted yield curve and little term premium, Russell-Dowe states that we are now in an environment in which yield on short-term cash investments exceeds investment-grade corporate indices. A highly unusual situation.
“Should the yield relationship between cash and corporate credit normalise, there may be a material impact on allocations, resulting in significant changes in demand,” she adds.
As allocation changes begin to move into other areas, Russell-Dowe entertains the possibility that already tight risk premiums may tighten even further.
With risk premiums today at historically low levels, she notes that diversifications and alternate sources of risk premiums may be increasingly desirable.
Noting the differences in borrower profiles and collateral quality, she notes that consumer debt portfolios can lead heavily towards financially insecure customers, particularly younger or lower-income borrowers.
This demographic could face significant risks, noting that recent higher delinquency trends are concerning.
According to Russell-Dowe, “the complexity of this environment necessitates that investors remain disciplined in their approach. Identifying inefficiencies in the market, particularly in private markets, will be key.”
Russell-Dowe notes that investors may be challenged by the flatness of the credit curves and high valuations in many sectors and return profiles today can be asymmetric.
As such, she reiterates the benefits of managing with reduced exposure to volatility.
