Anniversary: Two years of calls, checked

This column began in September 2022, as inflation soared and central banks raised rates in a panic. Two years later the cycle has come full circle, and the Federal Reserve is preparing its first rate cut. Looking back over two years of market calls teaches some humility about the cycle.

Where the cycle started

The starting point was extreme. That month the Fed raised rates by three-quarters of a point for the third meeting running, and in London a package of unfunded tax cuts sent gilt yields soaring and forced the Bank of England to intervene to protect pension funds. By the end of 2022 a US recession in 2023 was the consensus forecast. The Fed went on to lift its policy rate to 5.25 to 5.5 per cent by July 2023, and has held it there since.

The British episode was the clearest early sign of how leverage hidden in quiet corners could turn a rate shock into a crisis. Pension funds using liability-driven investment strategies had borrowed against gilts, and when gilt prices collapsed they faced collateral calls they could meet only by selling more gilts. The Bank's emergency purchases stopped the spiral, and Liz Truss left Downing Street within weeks. The lesson, that the damage from higher rates shows up first where borrowing is short-term and collateralised, has held throughout the cycle.

What the consensus missed

The consensus went wrong by underestimating how resilient corporate balance sheets were and how well locked-in low coupons on debt would cushion borrowers. It also missed how far federal deficits would offset tighter money. The laws of financial gravity still apply. Their effect was delayed. As rate cuts begin, the real test of post-pandemic debt structures is only starting.

The cushion was built in 2020 and 2021. With yields at record lows, companies issued long-dated bonds in huge volumes and pushed maturities years into the future, while American homeowners refinanced into 30-year mortgages at fixed rates. When the Fed tightened, few of them felt it. Many large companies held more cash than floating-rate debt, so higher rates lifted their interest income faster than their interest bills.

Europe offers a contrast. Mortgages in Britain and much of the euro area are fixed for far shorter periods, if at all, so higher rates reached households faster, and growth in both economies stalled for much of the past two years. The European Central Bank and the Bank of England both began cutting this summer, ahead of the Fed, in part because their economies felt the squeeze sooner. The structure of debt, more than the level of rates, determined how quickly tightening bit.

Deficits did the rest

Fiscal policy pulled the other way. The federal deficit reached about $1.7 trillion in fiscal 2023, an extraordinary figure for an economy at full employment, and subsidies under the Inflation Reduction Act and the CHIPS Act fuelled a boom in factory construction. Households were also still drawing on savings built up during the pandemic. The Fed was braking hard while the Treasury kept a foot on the accelerator.

Where higher rates did bite

Gravity showed up where debt was short-term or floating. Silicon Valley Bank failed in March 2023 after losses on its bond portfolio prompted a run on deposits, and Signature Bank and First Republic followed. Commercial property owners with floating-rate loans, and leveraged companies funded through private credit and leveraged loans, have faced sharply higher interest bills. Those corners of the market offer a preview of what awaits the rest.

Office buildings are the most visible casualty. Higher rates coincided with a lasting shift to remote work, so owners face both lower rents and higher refinancing costs at the same time. Values have fallen sharply, lenders have extended loans rather than force sales, and regional banks with large property books remain exposed. The pain has been slow because extensions buy time, which is the same pattern of delay that has run through the whole cycle.

The refinancing test ahead

The cheap debt of 2020 and 2021 does not last forever. As bonds mature over the next few years, companies will have to refinance at rates well above the coupons they are used to, even after the Fed has cut. August's payroll gain of 142,000, short of forecasts and accompanied by further downward revisions to earlier months, suggests the economy is losing momentum just as that bill starts to arrive. Even a series of cuts would leave borrowing costs well above what many issuers locked in when yields were at record lows.

There is a case that the reckoning will be mild. Companies have had two years to prepare, many have already refinanced their nearest maturities, and credit spreads remain narrow by historical standards, suggesting lenders are relaxed. If the Fed cuts steadily and growth holds, the refinancing wall may be climbed one step at a time. Spreads that stay tight while growth slows would be the first thing to crack if that hope proves misplaced.

Signals for the next two years

The indicators that matter now are the ones that track refinancing stress rather than headline growth. Default rates on leveraged loans and high-yield bonds, the volume of loans being amended and extended rather than repaid, and delinquencies on commercial property loans will show whether the cushion is running out. On the macro side, the pace of Fed cuts and the path of ten-year yields will determine the rate at which the next wave of maturities is refinanced.

The lesson for forecasters is about timing more than direction. Two years of forecasting show that cushions such as cheap fixed-rate debt can delay the effect of higher rates for a long time, though not forever. Companies refinancing over the next few years will find out what capital really costs. Expect defaults among lower-rated, floating-rate borrowers to keep rising even as the Fed cuts, while investment-grade companies with long-dated debt pass through largely unscathed.