US: Economic resilience despite higher rates – Part two

Faced with a significant increase in official interest rates, companies have been surprisingly resilient. Can this last in an economy which is bound to slow given the ‘high policy rates for longer’ environment? The Federal Reserve’s latest Financial Stability Report gives some comfort based on a comparison of corporate bond yields and spreads to their historical distribution. Moreover, resilient earnings imply a robust debt-servicing capacity. Does this assessment hold in a stress test scenario? A recent analysis of the Federal Reserve concludes that the debt-servicing capacity of the U.S. public corporate sector as a whole is robust to sustained elevated interest rates, unless in case of a severe economic downturn. Unsurprisingly, firms with balance sheets that are already weak, are far more sensitive to persistently higher interest rates or a severe drop in growth. Such a development might have repercussions for the broader economy through client-supplier relationships, the labour market and, possibly, a contagion effect in corporate bond markets.

As discussed in the previous issue of EcoWeek, faced with a significant increase in official interest rates, companies have been very resilient thanks to several financial factors: profitability, cash levels accumulated during the Covid-19 pandemic, the ease of capital markets-based funding, low long-term rates that had been locked in during the pandemic. The growing role of intangible investments also plays a role because they are less sensitive to interest rates, thereby weakening monetary transmission.

Can this resilience last in an economy which is bound to slow given the ‘high policy rates for longer’ environment? The Federal Reserve’s Financial Stability Report, which was published in April, gives some comfort. Yields for both investment and speculative grade bonds stand near the median of their respective historical distributions. Corporate bond spreads narrowed to levels that are low relative to their historical distributions. The excess bond premium -which measures the difference between corporate bond spreads and expected credit losses- remains near its historical mean. Moreover, interest coverage ratios (ICRs)—earnings before interest and tax divided by interest expenses— point to “robust debt-servicing capacity, reflecting resilient earnings.”

Nevertheless, going forward, close monitoring will be necessary considering that the economy is slowing -as shown by the decline in the hiring rate and the growth of nonfarm payrolls- whereas due to the stickiness of inflation, the FOMC argues it is in no hurry to cut rates. Besides, according to the Federal Reserve, “expectations of year-ahead defaults remained somewhat elevated relative to their history”, and vulnerabilities of unlisted small and middle-market firms are inching higher. In addition, there is still a concern about the delayed effect of past increases in the federal funds rate.

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