Payment defaults are starting to weigh more on the markets


Believe it or not, investors sometimes think of things that are not directly related to US interest rate policy.

Of course, the debate over what the Federal Reserve will do next is important. This is unquestionably the biggest problem at the moment. This week, it once again dominated the otherwise sleepy summer market conditions, thanks to data showing a slight slowdown in inflation.

The annual rate fell to 8.5% in July, the Bureau of Labor Statistics said Wednesday, from 9.1% the previous month, raising hopes that the Fed could be persuaded to ease the rate hike. interest. This so-called pivot has been on and off more times in the past month than I can remember. It has the lifetime of the core political program of a Conservative leadership candidate. But now, to some degree at least, it’s back, supporting stocks.

Certainly, this could be the start of something big. Maybe inflation will really come down from here. Maybe it was transient after all, if you can torture the definition of transient hard enough. But if you think the Fed is going to ease off with headline inflation at 8.5%, against its 2% target, I have a bridge to sell you.

“If we had zero percent inflation month-over-month every month (which would be incredibly accommodative) until the end of the year, we would still have inflation above 6% in December,” analysts note. Mirabaud. “The momentum may be slowing down but. . . 8.5% is still too high.

Mary Daly, chair of the San Francisco branch of the Fed, emphasized this point in an interview with the FT. “We don’t want to declare victory on lower inflation,” she said. “We’re not done yet.” Will that end this debate? No chance.

One problem is that this noisy exchange, important as it is, drowns out everything else. Meanwhile, many bond investors have another issue on their minds: defaults. These have been rather rare as central banks have flooded the system with free money, but failures by governments and businesses to repay what they owe are set to become much more frequent.

In the case of public debt, this could become very tricky, especially for countries that have borrowed in dollars which are now much more expensive to repay. Leland Goss, general counsel for the International Capital Markets Association, pointed out in a recent report that even in the decade before the Covid strike, borrowing in emerging markets fell from $3.3 billion, or about a quarter of economic output, at $5.6 billion, or almost a third.

The tension is starting to be felt in Sri Lanka, which has already admitted it cannot repay investors, but also in bonds issued by Kenya, Egypt and elsewhere. The prospect of a “possibly systemic sovereign debt crisis” is real, Goss said.

The nightmare scenario here is that many faults occur at the same time. “Creditors exposed to not one or a few, but many sovereign borrowers could face large aggregate exposures,” Goss said. “Creditors themselves could experience financial difficulties and potential systemic implications, particularly if they are financial institutions.”

This is indeed a potentially pressing issue for fund managers with concentrated exposures to emerging markets, and if Goss is correct, it is also worth keeping an eye out for. There is “no magic formula” to solve this problem, he said, but “coordinated and preventive multilateral debt restructuring” could at least put some order in the process.

Corporate debt investors are also prepared for a tougher environment. “I am not a pessimist at all,” says Pierre Verle, head of credit at European asset manager Carmignac. “I don’t expect an uncontrollable wave of defaults. But we are entering a world where capital has a cost.

The ICE BofA euro high yield index shows this very clearly. At the start of this year, yields – an indicator of borrowing costs – hovered at just under 3%. Remember this is for risky high yield borrowers, not gold plated safe issuers. It is now at 6%, having topped 7% in July when the central bank’s rate hike spree peaked.

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Rating agency Fitch estimates that with economic risks intensifying and benchmark interest rates rising, high-yield bond default rates could double in the United States this year, reaching 1%, and also double in Europe to reach 1.5%.

Verle thinks overall it could be a lot higher. “Over the next five years, I think you see a default rate of 4% per year, so over a five-year period, one in five will default in high yield. That’s a lot.” Levels like that would take us back to what we saw in 2020 – not a vintage year.

This does not alarm Verle – his previous roles in troubled debt markets have toughened him up for this experience. “I come from a debt background, so my expectations are very, very low,” he says. But others will probably find it more invigorating.

The spinning Fed pivot debate is sucking a lot of intellectual energy out of the markets, and for good reason. But look away from these other issues at your peril.

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