News in Charts: Sting in the tail of longer debt maturities

In Fathom’s Global Outlook, Summer 2023, we changed one of our key calls. We removed a global recession this year from our central scenario. At the time the forecast was finalised in early June, real wages in the US had already started to rise on a twelve-month basis. Our judgement was that this pattern would soon be repeated in the euro area and in the UK. Most major economies had got through the worst of the cost-of-living crisis without entering a period of economic contraction. There were one or two exceptions — the euro area had just suffered two consecutive quarters of falling output, driven by weakness in Germany. However, we felt the region was likely to return to growth before the year was out.

Against this backdrop, investor sentiment had switched firmly back to ‘risk-on’, and we anticipated further gains in broad equity indices through the second half of the year. Scroll forward a couple of months to the present day, and we find that the S&P 500 has continued to drift higher as the VIX ‘fear gauge’ has fallen. The euro area and the UK look to have expanded by 0.3% and 0.2% in Q2, respectively. The UK press went further this week by also declaring an end to the cost-of-living crisis, with wage inflation finally expected to outstrip CPI inflation. So far, so good.

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But there was a caveat to our apparent optimism back in early June. The message of our previous forecast was very much ‘one bullet dodged’: there were still two in the chamber. We named the two remaining bullets (or risk scenarios) ‘It’s out for delivery’ and ‘Sticky inflation’. In the first of these, the full effect of the monetary tightening that was already in place had yet to hit home. Recession was already inevitable, and it was just a matter of time. Tightening cycles often end in recession, with a lag that can range from less than a year (the hiking cycle that began in late 1980) to almost four years (the hiking cycle that began in mid-2004 and triggered the GFC).

Since finalising our previous forecast, we have detected among other forecasters a growing sense of optimism that recession can be avoided, full stop, despite a more rapid tightening of monetary policy across the major economies than we have seen in decades. This time, in other words, will be different, with many seeming to pin their hopes on the protection offered by rising debt maturities, in part for corporates but particularly for households. Below, we explain why, from the perspective of avoiding recession, longer debt maturities are something of a red herring.

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In the US, 30-year fixed-rate mortgages are the norm, and have been for some time, with the share of adjustable-rate mortgages (ARMs) in total loan applications averaging less than 10% since the GFC. This means most US mortgagors are insulated not just from the month-to-month decisions of the FOMC, but in many cases from whole hiking cycles. In the UK a similar equilibrium has been establishing at the 5-year window with the proportion of variable-rate mortgages in the stock falling from around 60% nine years ago to just 12.4% today.

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Similarly, long corporate debt duration was becoming more and more accepted over the years after the Global Financial Crisis (GFC). The loose monetary policy meant that in the search for investment returns, investors were willing to turn less risk averse, accepting longer debt maturities and gifting longer fixed-interest payment windows. From the perspective of avoiding recession, longer debt maturities must surely be a good thing? We are not convinced.

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Longer debt maturities protect the borrower from interest rate risk, but at the same time they expose the lender. There is no free lunch here. When rates rise unexpectedly, the firm or household that chose to borrow long term will experience relief. But the lender sitting on the other side will experience regret to just the same degree. Banks will typically hedge their exposure to interest rate risk – though not always (witness the experience of Silicon Valley Bank). Nevertheless, some counterparty somewhere will be sitting on the wrong side of that deal. At best, longer debt maturities may lengthen the lags between changes in monetary policy, and changes in the real economy, but they do not protect one from the other entirely. If one part of the chain is hit by the hikes, then credit supply ought to take a blow at some point. This is the risk scenario that Fathom constantly monitors and the materiality of which we will try to gauge in our upcoming Global Outlook, Autumn 2023.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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