What Does the Interest-Rate Outlook Mean for Private Credit?
After a period of tight monetary policy that began in response to rising inflation levels in late 2021, interest rates have finally started to fall. On 6 June, the European Central Bank (ECB) became the first major institution to reduce borrowing costs, and both the Bank of England (BoE) and the US Federal Reserve (Fed) are expected to follow suit later in the summer.
It seems highly unlikely that the multiple rate cuts investors had originally predicted for 2024 will materialise.
However, it seems highly unlikely that the multiple rate cuts investors had originally predicted for 2024 will materialise, with policymakers on both sides of the Atlantic appearing increasingly cautious in recent months. In January, it was reported that investors in the UK were forecasting four quarter-point reductions by the BoE over the course of the year, a schedule that would take the base rate from 5.25% to 4.25%1. Now, the consensus view is that there will be just one or two rate cuts in the UK this year2.
Markets in the US were even more bullish at the turn of the year, with traders pricing in six rate cuts by the Fed in 2024 – moves that would have resulted in the federal funds target rate dropping from the current 5.25%-5.50% range to 3.75%-4.00%3. By June, however, investors were factoring in just a single reduction before 20254.
So what has changed in the last six months – and what does this mean for the future path of interest rates? The main sticking point when it comes to loosening monetary policy has been inflation. While the pace of price rises in the US and Europe has continued to fall over the past six months, progress towards the target level of 2% has been uneven. At the same time, the kind of negative economic impact that many analysts thought would result from a prolonged period of high interest rates has not been in evidence – at least, not yet.
The main sticking point when it comes to loosening monetary policy has been inflation.
The eurozone and UK economies did endure a slight slowdown towards the end of 2023, but in recent months there have been some tentative signs of recovery. The US, meanwhile, has been considerably more resilient than expected, with continued strength in the country’s labour market as well as areas such as retail spending and manufacturing. Against this backdrop, there is less pressure on central banks to worry about the economic impact of high rates – and more reason for policymakers to be concerned about the re-emergence of inflationary pressures such as wage growth.
As well as taking considerably longer than forecast to start cutting rates, central banks have also made significant efforts to temper the market’s expectations when it comes to the future course of monetary policy. While rates seem certain to fall further over the course of this year and next, the likelihood of an imminent return to the ultra-low borrowing costs of the last decade seems remote.
Between 2009 and 2020, the average rate set by the Fed in the US was 0.7%, while in the euro area and the UK, it was just 0.5%5. Given that rates were so low for such a long period, it is not surprising that markets came to view this as ‘the new normal’. But there are strong reasons to believe the monetary conditions of the last decade were an anomaly, and that rates in future are likely to revert closer to historical averages at somewhere around 4% or 5%. In the wake of the global financial crisis, central banks were under pressure to provide economic stimulus, which they did by cutting rates and engaging in programmes of quantitative easing. At the same time, inflationary pressures remained subdued until the Covid-19 pandemic of 2020 – so there was little reason for policymakers to worry that rates were too low.
Today, the picture is very different. While inflation appears to have been brought under control – and has recently returned to its 2% target in the UK – factors such as challenges in international supply chains and geopolitical tensions mean the threat of rising prices should not be discounted. Increasing wages are expected to add to the problem: the April 2024 uplift in the National Minimum Wage in Britain is likely to feed through to higher costs for businesses, and it will not be a surprise if the new Labour government introduces policies that offer further support to workers. Meanwhile, central banks are continuing to sell the vast quantities of bonds that were bought as part of their post-financial crisis quantitative easing programmes – a process that depresses bond prices and provides further support for yields.
Businesses may have been reluctant to lock in to fixed-rate finance deals at a time when interest costs were high, and were expected to fall. However, the prospect of rates remaining only slightly below current levels for the foreseeable future means that the calculus around the choice of fixed- versus floating-rate deals has changed, with longer-term Gilt and Treasury rates no longer expected to fall significantly below today’s levels in the current cycle.
At the same time, we have already seen an element of policy divergence among the major central banks, with the ECB choosing to cut rates while the Fed and the BoE maintain their wait-and-see approaches. For firms with international exposure, the currency flexibility offered by private credit presents opportunities to take advantage of the fact that rates are falling in some regions but not in others.
Businesses that are able to diversify their sources of capital through alternative finance can reduce the risks they face during periods of market turbulence.
But if we have learned anything from the volatility of the post-pandemic period, it is that the future is very difficult to predict with confidence. As such, businesses that are able to diversify their sources of capital through alternative finance can reduce the risks they face during periods of market turbulence. In addition, by opting for finance that is longer-term in nature, businesses may be better placed to look past short-term challenges, gaining a significant degree of stability in uncertain times.
All investments involve risk, including the possible loss of capital. Past performance is not a guarantee or a reliable indicator of future results.
This information is for informational or educational purposes. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM Private Capital is not acting as your fiduciary. These materials represent the views, opinions and recommendations of the Author as of July 19, 2024 regarding the economic conditions, asset classes, securities issuers or financial instruments referenced herein. These are subject to change at any time and may differ from the views of other members of PGIM Private Capital as whole. Distribution of this information is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Private Capital is prohibited.
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