Byline on Interest Rates
[client work; per mid-2021; written for client distribution and to accompany a presentation (statistics used in the article are found and cited in presentation)]
Since the start of the COVID-19 pandemic, we’ve witnessed unprecedented sums of stimulus spending. The U.S. has responded to the COVID-19 crisis with approximately four times more relief than following the Global Financial Crisis, having spent 6% of GDP in 2009 versus 27% in 2020 and 2021. So far, this has powered a strong economic recovery.
The recovery, however, hasn’t reached everywhere. Segments of the employment market remain weak, with overall jobs remaining well below their post-pandemic trendline. For this reason, we expect support from the U.S. government and other central governments around the globe to continue in the short run.
This incredible stimulus, along with the possibility for more, turns our eye towards the largest driver of markets: interest rates. At some point, interest rates will have to push upwards but it isn’t clear how or when. We are adjusting our outlook to reflect uncertainty around rates and applying our experience to capture opportunities that stem from a rising-rate environment.
Recovery and Support
Taking a closer look at the recovery, we see that U.S. household balance sheets went from a relatively good position to a better one. The share of disposable income that went to savings increased dramatically (by nearly 10 percentage points) in 2020, and the share of disposable income going towards debt payments remains at a multi-year low.
But these trends have not played out equally across the income spectrum. Employment in particular has had disparate outcomes: while top-quartile earners have improved their situation over the past twelve months, employment for the bottom quartile fell by nearly eight million jobs. In the second to bottom quartile, employment fell by three million jobs.
The Fed has made it clear that it will prioritize broad economic recovery over the risk of inflation, a word which strikes fear into those experienced in markets before the turn of the century. In fact, the Fed has recently suggested a shift in their evaluation of market health, indicating that they will look to the lowest earning group rather than broad averages. In addition, the Biden administration has made clear a desire to provide the cash necessary to boost employment for low earners.
Meanwhile in the financial markets, default rates have made a remarkable reversal. Off from peaks in late spring of 2020, defaults for high yield bonds and leveraged loans have cooled off tremendously with only two high yield defaults in March 2021. This news is a welcome sign for credit markets.
The Big Risk and Opportunity
All this information paints a muddy picture. We have a bifurcated but positive-trending consumer market and strong corporate balance sheets, as well as a desire for continued monetary and fiscal stimulus. So, what happens from here? There is opportunity amid risk, and treasury yields may provide our best insights.
The 10-year nominal rate halved during the pandemic but has since seen a sharp rise in 2021, now approaching pre-pandemic levels just below 2%. Real rates, on the other hand, are still negative from the large sums of spending and are slowly inching back towards zero.
If real rates don’t climb quickly enough alongside economic recovery – which appears a probable, given the Fed’s eye on bottom quartile employment – we believe it’s likely that the market will start to take back some of that yield. For us, this presents the biggest risk to the credit markets today. Folks don’t want their fixed yields crushed as real rates rise.
But this is also where opportunity lies. Short term, consumer-oriented credit is attractive, as are the private credit markets where opportunity for yields are significantly less limited. In March 2020 there were better opportunities in public markets, which at the time were much more dislocated. This trend has reversed itself a year later.
We’re also looking at corporate structured credit. A nice risk premium still exists in this market, and default likelihood in the short-term is low as the refinancing cycle has pushed most of that risk down the road. For each of these investments, you don’t need long-term economic views, just 12-month convictions, such as the maintained recovery of the top income group.
Perhaps the biggest source of alpha we see in the market, though, isn’t a specific asset class or sector: it’s an experienced team. [redacted paragraph]
Right now, [redacted] taking on risk premiums that are driven by near-term economic conditions and government support and avoiding those that take unnecessary interest rate exposures. If real rates begin to climb as we anticipate, we will be ready.