Booming markets neutralise impact of rate rises on US corporate fundraising

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Rising stock prices and falling bond yields have made it so much easier for US companies to raise funds that much of the impact of the Federal Reserve’s interest rate rises has been neutralised, according to investors and several closely watched measures.

The degree to which the environment has improved in recent weeks is reflected in the National Financial Conditions Index, compiled by the Chicago Fed, touching its lowest point in 16 months.

However, looser financial conditions run counter to the Fed’s goal of slowing the economy to bring inflation under control, and make it more likely the Fed will have to keep interest rates higher for longer.

“The reality is that financial conditions have loosened — we have [effectively] unwound roughly 450 basis points of rate hikes. Financial conditions are enough to take us back to March of last year,” said Sonal Desai, chief investment officer for Franklin Templeton Fixed Income. 

“As the market comes around to the belief that we are not going to have a recession, that implies that demand will remain strong, [and] that implies that we will not have any need to cut interest rates.”

The more benign fundraising environment comes as the Fed has jacked up interest rates from near-zero in March last year to more than 5 per cent, with a further 0.25 percentage point raise on Wednesday. Following the Fed’s latest increase, Goldman Sachs’ daily US Financial Conditions Index dropped, approaching the low it hit in mid-July, which marked the loosest conditions in a year. 

This is because the looser conditions reflect a view among investors that the Fed has effectively finished raising interest rates since its main focus is bringing down inflation — which has fallen sharply in recent months.

“I would say that conditions right now are loosening, probably to the chagrin of the Fed,” said Andy Brenner, head of international fixed income at Natalliance Securities. “But as long as the Fed gets better inflation numbers, they’re going to care less and less.”

But they also reflect dynamics in stock and corporate bond markets that have bolstered sentiment: enthusiasm about artificial intelligence has driven US stocks into bull-market territory this year, and a shortage of new deals in the junk-bond market has driven investors into the few that have been on offer. 

Line chart of Chicago Fed National Financial Conditions Index showing US financial conditions are at their loosest since March 2022

The premium that low-rated companies have to pay to borrow is now around its lowest since April 2022, with the gap between junk bond yields and Treasuries narrowing by roughly 0.9 percentage points between the end of last year and July 26 to approximately 3.9 percentage points

Investors say the tightening of spreads this year has been fuelled partly by a shrinking junk bond market — with relatively low new issuance and several upgrades to “investment grade” territory helping to anchor prices at artificially high levels. Higher overall credit quality and waning fears about an imminent recession have also buoyed valuations.

Noting the narrowing of credit spreads and the broader loosening of conditions, Brenner said: “People are coming off the sidelines.” 

“In some respects, banks are tightening their lending standards”, he added. “But private credit has come to the rescue. If you need money, you can get it — one way or the other . . . It might be a little more expensive, but money is available.”

However, Mike Chang, a high-yield portfolio manager at Vanguard, said financial conditions had not loosened across the board. “The market is still discriminating between stronger and weaker issuers and many weaker issuers still don’t have access to capital markets.” 

“Higher interest rates generally take time to work [their] way through the economy and through corporate balance sheets”, Chang added. “Given how much refinancing activity has occurred over the past several years in the high-yield market, it will take more time for maturities and refinancing to become a larger issue.”

Line chart of Option-adjusted spread over US Treasuries (percentage points) showing Junk bond spreads have narrowed this year

Equity markets have risen on the back of enthusiasm for big tech stocks tied to the growth of artificial intelligence. The S&P 500 has climbed almost 20 per cent year to date, making it easier for companies to raise cash through share sales. Fundraising through US initial public offerings is up 104 per cent year on year, according to Dealogic data, while follow-on sales by listed companies and their shareholders are up 65 per cent.

Economic growth data published on Thursday provided further signs of the encouraging environment for businesses, with a sharp increase in business investment driving the stronger-than-expected increase in gross domestic product.

Markets will closely scrutinise next Monday’s Senior Loan Officer Opinion Survey on Bank Lending Practices, after the last quarterly report by the Fed found that banks expected to tighten lending standards over the rest of 2023. 

Fed chair Jay Powell acknowledged the potential risks from easing conditions after the central bank announced its latest interest rate rise on Wednesday. He told journalists that “if financial conditions get looser we [may] need to do more”, but said he was confident interest rates were affecting economic activity and inflation.

“What tends to happen is financial conditions get in and out of alignment with what we’re doing [but] ultimately over time we get where we need to go.”

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