Rate Cut Uncertainty

Our Head of Corporate Credit Research explains why leveraged loans would benefit if bumpy inflation data leads the Federal Reserve to delay interest rate cuts.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I’ll be talking about the ramifications of the fed rate cuts, and what it could mean for credit – and what would benefit if rates stay higher for longer. It's Friday, March 15th at 2pm in London.

The big story in markets this week was inflation. U.S. Consumer Price inflation continues to moderate on a year-over-year basis, but the recent path has been bumpier than expected.

And as U.S. Economic growth in the first quarter continues to track above initial expectations, there’s growing debate around whether the U.S. economy is still too strong to justify the Federal Reserve lowering rates.

Morgan Stanley’s economic base case is that these inflation readings will remain bumpy – but will trend lower over the course of the year. And if we couple that with our expectations that job growth will moderate, we think this still supports the idea that the Federal Reserve will start to lower interest rates starting in June.

Yet the bumpiness of this recent data does raise questions. What if the Federal Reserve lowers rates later? Or what if they lower rates less than we expect?

For credit, we think the biggest beneficiary of this scenario would be leveraged loans. For background, these represent lending to below-investment grade borrowers, similar to the universe for high yield bonds. But loans are floating rate; their yields to investors rise and fall with central bank policy rates.

Coming into 2024, there were a number of concerns around the levered loan market. Worries around growth had led markets at the start of the year to imply significant rate cuts from the Fed. And that’s a double whammy, so to speak, for loans; as loans are both economically sensitive to that weaker growth scenario and would see their yields to investors decline faster if there are more rate cuts. Meanwhile, an important previous buyer of loans, so-called Collateralized Loan Obligations, or CLOs, had been relatively dormant.

Yet today many of those factors are all looking better. Estimates for US 2024 GDP growth have been creeping up. CLO activity has been restarting. And some of this recent growth and inflation data means that markets are now expecting far fewer rate cuts – which means that the yield on loans would also remain higher for longer. And that’s all happening at a time when the spread on loans is relatively elevated, relative to similar fixed rate high yield bonds.

A question of whether or not U.S. inflation will be sticky remains a key debate. While we think inflation resumes its improvement, we like leveraged loans as a high yielding, floating rate instrument that has a number of key advantages – if rates stay higher, for longer, than we expect.

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