What does the delay in Fed rate cuts mean for the economy and credit?

With the Federal Reserve now looking set to delay a rate cut until at least the fourth quarter, borrowers that were waiting for lower rates to refinance debt (especially those at the lower end of the credit spectrum) could get squeezed.

What we’re watching:

After the Fed held its policy rate at 5.25%-5.50% at its May 1 meeting, Chair Jerome Powell said that rate cuts won’t occur until policymakers are confident that inflation is on a sustainable path toward the central bank’s 2% target (barring an unexpected weakening in the labor market).

In this light, S&P Global Ratings now believes that conditions for an easing of monetary policy won't be in place before autumn, and we revised our forecast for a cut in the federal funds rate, which we now expect will come in December—several months later than we previously forecast.

The Fed has reinforced the idea that its deliberations are data-dependent. Just as the Federal Open Market Committee (FOMC) was cautious about the encouraging inflation data in the second half of 2023, it’s unlikely to overreact to upside inflation surprises in more recent readings. Powell has reiterated his previous guidance that the central bank doesn't need to see year-over-year inflation at target, but rather “several months” of inflation at an annualized rate near 2% to be confident that inflation will get there.

What we think and why:

When we laid out our projected trajectory of rate cuts in March—with a forecast for 75 basis points (bps) of cuts this year, starting in July—we said the balance of risks was tilted toward a delayed first cut, a slower pace of easing, and higher year-end rates for 2024 and 2025. Those risks materialized with the unexpectedly strong economic data that has come in since then.

Some of that data points to the underlying momentum of the U.S. economy. And while inflation readings from the past three months likely overstate the remaining price pressures, they still lower our confidence in a rate cut happening before autumn—especially given the upside risk to our inflation outlook due to strong consumer demand.

From a credit perspective, continued high borrowing costs and the pressure they exert on borrowers’ liquidity remain the top risk identified by the North America Credit Conditions Committee. If interest rates remain elevated for even longer than we anticipate, the costs of debt service and/or refinancing could be overly burdensome—especially for lower-rated borrowers.

With near-term maturities looming for U.S. speculative-grade borrowers, some of these borrowers may feel more severe liquidity strains, particularly if investors become more risk-averse. Challenging financing conditions could also lead to significant declines in asset valuations, including a housing slump or a deepening correction in commercial real estate.

The Fed's announcement that it will slow the pace of reductions in holdings of U.S. Treasuries from June onwards is a factor mitigating the risk of an unwarranted tightening of financing conditions.

That said, improving financing conditions in the first quarter gave borrowers a window of opportunity to refinance upcoming debt. U.S. corporates have reduced upcoming maturities, with speculative-grade nonfinancial maturities remaining in 2024 down 20% since Jan. 1, while 2025's maturities are down 16%. 

But markets can change quickly, and financing conditions may become more challenging. Investors have tempered their expectations for rate cuts, credit spreads could widen, and conditions for refinancing may be turning less favorable.

What could change:

Our recalibrated forecast is by no means a guarantee. The risks to our assumption for the timing of the first Fed rate cut are two-sided. On one hand, if labor market conditions weaken quicker than we anticipate, the Fed could become more sensitive to its employment mandate, and, in such a scenario, could begin easing sooner than our assumption even as inflation remains well above the 2% target. On the other hand, the Fed could keep its policy rate where it is through year-end if inflation doesn’t show a sustainable slowdown. And there's no shortage of upside risks—from lingering excess demand to supply-related shocks that could further fuel price pressures and spur another rethinking of rate-cut expectations.

Still, we don't foresee a need for the Fed to hike borrowing costs again. Inflation may be too high to justify cuts, but it’s also not hot enough to warrant restarting the tightening cycle. The risk of there being no rate cuts this year has risen, but we continue to believe that disinflation will resume in coming quarters.

Even without another rate hike, the risk that the Fed will wait too long to ease and thus plunge the world’s biggest economy into recession can’t be dismissed. We think the most likely path is the one where real GDP growth slows to below potential, with annualized monthly inflation consistently at or around 2%, such that the Fed gains more confidence to lower its policy rate by year-end. Again, there’s no guarantee this will be the case.

Even as American consumers seem to be generally unbothered by high borrowing costs for now, it would be a mistake to think that the strains from high rates aren’t creeping into the economy. Income growth has significantly lagged spending growth since the middle of last year, with consumers increasingly reliant on credit and savings. Excess savings are likely depleted for all but the highest-income households, and delinquency rates on credit cards and auto loans have risen beyond pre-pandemic levels. We think consumers will rein in their spending even further.

The prospect of delayed U.S. policy rate cuts has a material impact on some other economies, too, through two main channels: exchange rates and financial conditions. We now expect most Asia-Pacific central banks and those in other emerging markets to delay and slow their policy-rate reductions compared with our earlier expectations. This reflects the sensitivity of capital flows and exchange rates in the region to interest differentials with the U.S.

Several central banks want to contain depreciation pressures to limit the impact on inflation via higher import prices while some will adjust their plans to the new U.S. rates outlook to avoid currency weakening from encouraging capital outflows. As for Europe, we don't think that the latest Fed announcement will postpone most central banks' rate cuts, although upside risks to our European long-term yields forecast have increased.

CreditWeek, Edition 28

Contributors: Satyam Panday

Written by: Joe Maguire