JP’s Journal: Lower Yields and Financial Stability

The US Federal Reserve (Fed) kept rates on hold (range 5.25% – 5.5%) and signalled 75 basis points (bps) of cuts for 2024. Whilst further hikes were not ruled out there was a pivot in Fed communications, with an acknowledgement of rate cut discussions and a more optimistic inflation outlook. Investors took this in a bullish way, supporting the soft landing ‘Goldilocks’ scenario of disinflation but no recession. Fair enough, there was messaging that inflation was not guaranteed to reach the 2% target and the more dovish tone was not universal with some expecting no cuts in 2024. But this was drowned out; 10-year US treasury yields ended below 4%, a 30bps fall on the week.

In the UK, the Bank of England (BoE) kept the interest rate at 5.25%. There was surprise that three members still voted for a rate hike, despite increasing signs of economic slowdown. The Monetary Policy Committee statement indicated that the decision was finely balanced – but this was not the reality in my opinion. The BoE’s stance is that monetary policy needs to remain sufficiently restrictive for a long time, but markets know better. The labour market remains the conundrum, with strong pay growth and persistent inflation being cited by the more hawkish members. Governor Bailey voted for holding rates but downplayed the recent fall in wages and softening of the labour markets. Looking at what is now priced into markets, we can see that the UK Base Rate is projected to be around 4.25% in November 2024, 100bps lower than the current 5.25%. This is less of a fall than is priced into US curves, where a drop of nearer 150bps is priced.

The European Central Bank (ECB) decision on interest rates was as expected: no change. The main surprise came from an earlier than expected timetable for a reduction in the ECB’s balance sheet, implying faster withdrawal of monetary stimulus. There was also an update to economic projections for the eurozone, which showed a slight downgrade of the growth outlook. At the accompanying press conference, ECB President, Christine Lagarde, emphasised that monetary policy remained accommodative and that the that there should be a clear distinction between the end of the hiking cycle and the start of the easing cycle. Nevertheless, despite the rhetoric, investors are pricing in 150bps of cuts over the next year.

So central banks are doing their job. Telling investors that inflation is not beaten, that the option of further monetary tightening is there and that rates will only be brought down gradually. The trouble is that most investors do not believe this – hence the pricing we are seeing. From our perspective, we have been positioned for lower government bond yields – prematurely in the second quarter – but the recent rally has been greater and swifter than we expected. This has shifted the risk/return profile and we have cut back on government bond duration into this latest move.

The Bank of England Financial Stability Report is not everybody’s preferred bedtime reading, although it may serve a purpose. Therefore, I am grateful to my colleague Peter Hensman for his synopsis. The BoE report highlights the risks in private credit and leveraged lending – bilaterally negotiated between borrowers and lenders. It is typically arranged by non-bank financial institutions and has been growing as an alternative source of finance. One of the risks identified by the BoE is that private credit appears particularly vulnerable to a worsening macroeconomic outlook and that company financing could be switched off in times of distress. How much risk has been transferred from public high yield markets to private credit?

I asked Will Nicoll, our newly appointed Head of Private Assets, to give his assessment of risks. It is worth quoting his response:

“Over the past few years, the European direct lending market and the European loan market have become competitors. The initial direct lending funds set up from 2010 were looking to complement the banking markets (like the syndicated loan market) as there was not enough money around. As liquidity increased through the various quantitative easing policies, the banks came back into a number of private markets and crowded out some of the direct lending activity. However, at the same time some loan investors used the extra liquidity to move into direct lending and sought to disintermediate the banks. They were very successful in raising money and so became desperate to be able to deploy the money.

This led to the unusual situation where an illiquid and inefficient market – direct lending – was willing to offer better terms to borrowers than a relatively liquid and efficient market – the syndicated loan market. At the same time, the banks have been very willing to offer leverage to these funds which exacerbated the problem.

Regulators have belatedly realised that there are now some very large direct lending funds which have taken on leverage and have also not had to mark any assets to market. The risk is that there is some stress/distress in these portfolios (because interest rates have gone up and economic growth is slow) that investors are not aware right now; managers are hoping that rates come down fast enough to be able to refinance their positions.

I am not sure that the problem in some direct lending funds is actually a systemic problem. However, the risk is that clients may well become quite disappointed with their returns from these assets in the next couple of years and that a refinancing wave hits at the same time that banks are pulling back (as they are now) and clients stop increasing allocations to this kind of direct lending funds. That could bring some exciting opportunities for a fund manager that does not have a back book.”

I look forward to working with Will as he looks for these opportunities.