- Fed cutting cycles can be broadly categorised into (i) aggressive cuts into a deep recession;
- or (ii) recalibration as a soft-landing takes place
- Current conditions lean towards a soft-landing
- Key risks to watch: Cratering of the job market and US election outcomes
- Corp credit opportunities: duration; corporates with high floating debt; ASEAN banks; perpetuals
As the Fed kickstarted the cutting cycle with a decisive 50 bps cut in September, it becomes crucial to identify the correct regime we are in, and accordingly, consider the amount of risk to take. Fed cutting cycles can be broadly categorised into two – aggressive cuts into a deep recession, or recalibration as a soft-landing takes place. The performance of various asset classes differs under different scenarios. Notably, under past recession scenarios, gold had been the best performer. Risk assets (high yield credit and equities) fared poorly, while investment-grade (IG) returns lagged those of Treasuries. Under past soft-landing scenarios, however, stocks became the best performer, and IG credit performed better than Treasuries and high yield (HY) credit.
Current conditions are leaning towards a soft-landing scenario. While there are some signs of cooling in the US labour market, the overall data does not suggest that the economy is falling off a cliff. In fact, the Atlanta Fed GDP nowcast is tracking at 2.9%, significantly above trend of around 2%. In any case, an unemployment rate of 4.1% is still considered low. With NFP figures and jobless claims largely well-behaved, there is a reasonable chance that the Fed would be able to avert a hard landing. Notably, Fed Chair Powell's decision to begin with a 50 bps rate cut highlights his heightened concern about the downside risks facing the economy. Additionally, such a substantial cut signals the momentum for a broader easing cycle, implying that further rate cuts could follow in the upcoming meetings. Sectors and economies across the globe that have been held back by high financing costs have suddenly been given a lifeline.
Though the extent of cuts is debatable, the crux for credit lies with how well financial conditions stay within the Goldilocks zone. Firstly, as long as the Fed is committed to an easing path, there will be some tailwinds to fixed income. Secondly, even if longer term rates do adjust higher (as in the event of upside surprises in NFP, for example), the upside might be capped to 20-30 bps, as it is clear that the Fed does not want real policy rates to be too high. One or two strong NFP prints will not stop the Fed from cutting. Accordingly, the scenario of firm US data driving a sharp sell-off in USTs and, in turn, triggering wider spreads, appears to be unlikely.
Corporate credits are set to benefit from rate cuts. In the earlier parts of September, credit spreads tightened across US and Asia IG/HY indices in anticipation of the FOMC meeting outcome. Shortly after the meeting, credit spreads tightened further and approached 12M lows. HY spreads saw larger tightening (11-23 bps) than IG spreads (2-3 bps). Lower refinancing rates and tight credit spreads are expected to bolster new issuances.
An environment of lower rates and tight spreads is favourable for corporates to tap the bond market. Corporates with a high percentage of floating debt could experience some reprieve as rates decline. Though new issuances had slowed in September ahead of the FOMC meeting, following the rate cut, there was a surge in issuance, particularly in the financials and state-owned enterprise (SOE) space. In the SGD space, issuance activity has tapered off after an initial spike from foreign financial institutions capitalising on lower swapped funding costs.
Where Credit Opportunities Reside
Opportunities remain open for investors. We expect fundamentals for Asia corporates to be supported as we enter the Fed’s easing cycle. We highlight several themes that will benefit: (i) long-duration credits, (ii) corporates with high floating debt, (iii) loan growth momentum in ASEAN banks, (iv) perpetuals.
With current economic data suggesting a soft landing as the base case scenario, we maintain a positive outlook for IG credit and duration extension. Further rate cuts will enable investors to lock-in attractive yields and capitalise on potential capital appreciation from long-duration credits. The recent bull steepening in USTs has led to the normalisation of the 10Y2Y spread, providing a term premium for taking on duration risk.
Next, key overnight benchmark rates have seen a significant decline of -5% to -11% (against YTD 2024 average). We believe lower floating rates will benefit SGD issuers with high proportions of floating rate debt (as a percentage of total debt), particularly those with more than 30%. Key beneficiaries in the SGD space include: (i) developers with estimated 30% – 60% in floating debt; (ii) investment managers with estimated 32% – 39% in floating debt, who may also see AUM growth as lower cost of funds improve capital raising and transaction flows; (iii) REITs & business trusts with estimated 12% – 45% in floating debt.
Another theme to consider would be ASEAN banks. The direct impact of rate cuts on banks will be on net interest margin (NIM) and net interest income (NII). While it may be seemingly expected that NII should decline, we maintain the view that the impact on banks in Indonesia, Philippines and Thailand will be moderate. Firstly, pressures on cost of funding have been more pronounced compared to lowering of loan yields since late-2023, and a rate cut will provide relief to cushion NIM decreases. Secondly, lower rates will support the loan growth momentum (in Indonesia and Philippines) and could spur lending (in Thailand – amidst other government initiatives). Both factors will bolster the negative impact of lower loan yields. Philippines and Indonesia both saw 25 bps rate cut YTD.
On 10 Sept, Australian banking regulator APRA announced plans to scrap AT1 bonds for banks, following a Swiss bank AT1 wipeout in 2023. Larger banks may replace 1.5% of AT1 with 1.25% Tier 2 and 0.25% CET1 capital, and the smaller banks would be able to replace the entire AT1 with Tier 2. If APRA’s proposal goes through, the transition will start in January 2027, with all current AT1 bonds on issue expected to be replaced by 2032. Following the announcement, the impact on Aussie AT1s has been moderately positive (implied maturity/call), and negative for Tier 2s. We doubt the structure would be widely adopted given losses are absorbed at the extremities of the capital stack; for equity (going concerns include AT1 exposures) and Tier 2 (gone concern). It would appear to be a step back to days prior to Basel III prior to GFC. Replacing AT1 with CET1/Tier 2s could reduce equity dividends and raise cost of funding for Tier 2s (more if ratings on Tier 2 instruments were to be lowered). As of June 2024, CET1 ratios of the big 4 Aussie banks averaged 12.6%.
Lastly, the SGD perpetuals market thawed with four new issues in August 24 as 5Y SORA retreated 100 bps from April’s high of 3.3% to a low of 2.3% at the start of August (current: 2.26%). Two out of four issues were for refinancing of existing perpetuals with up to 90 bps of cost savings. We continue to advocate for pull to par as lower benchmark rates incentivise corps to call existing perps even without reissuance (six perpetuals called between Apr - Oct 24 were not replaced). We also maintain that perpetuals with IBOR exposure and no fallback language have a high call probability.
Figure 1: 6M historical returns of various asset classes post first Fed cut (US securities)
Source: Bloomberg, DBS
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