Published in The Australian - 9 October 2023

Markets have hit the wobbles as “higher for longer” interest rate expectations and the removal of 2024’s interest rate cuts threaten to deliver a crushing blow to valuations the world over.

Many folks in markets are now expecting a market crescendo or credit event as we approach the lower liquidity year end period.

Higher for longer interest rate expectations – i.e., removing expected rate cuts and keeping central bank rates at recent historical elevated levels – have caused indigestion across the complex of both bonds and equities, forcing a nasty reassessment of the “soft landing” outcomes we are all hoping for.

It does, however, seem incongruous to us that “higher for longer” and “soft landing” can coexist. There is significant irony in the linkage that those very soft-landing expectations – and thereby the failure to tighten financial conditions via lower asset valuations, wider credit spreads, less spending and consumption – will ultimately lead to a hard landing by generating a credit event under higher bond yields. By driving interest rates higher, asset markets will question debt sustainability and refinancing risks, which can trigger a negative and pro-cyclical pricing loop.

Investors have been conditioned and calibrated to expect support via rate cuts and policy intervention (such as quantitative easing, or QE) at each nasty market episode since the Global Financial Crisis. It is perhaps a “take your medicine” moment, where the expected macro slowdown is met with minimal market support, characterised by limited rate cuts and QE programs. Without ongoing policy interventions and smoothing over each crack in the complex, it is a stand on your own feet moment of genuine price discovery, to forcibly achieve the ultimate goal of fully extinguishing inflation. This is a tremendously difficult backdrop for risk markets, characterised by higher funding costs, the rebirth of credit defaults and delinquencies, all underscored by the prevailing trend of slowing economies. The difference between a benign or destructive outcome comes down to the magnitude and rate of change to the growth outlook, as a result of these market moves.

Higher for longer interest rates are supposed to cause pain; tightening financial conditions to bring economies back to equilibrium, thereby normalising inflation.

Policymakers are walking a delicate tightrope, often described as the pursuit of “immaculate disinflation” in financial markets – the unicorn outcome of threading the economic needle in highly complex systems still affected by the aftershocks of Covid-19 shutdowns and reopenings.

Being able to achieve those outcomes without a few bumps along the journey seems highly unlikely.

So far, the recalibration of equity markets to higher bond yields and changing narratives has been somewhat orderly. While the drawdowns have been like the Silicon Valley bank episode of quarter one of this year (around -7.5 per cent), it has been a consistent and slow leakage, with little of the evidenced panic seen in markets at that time. Let us all hope that the concerns among market participants, sensing the potential for more disruptive moments for the first time since the Regional Banking crisis, remain unfounded. However, there are indeed plenty of potential pockets of concern that warrant attention.

The refinancing of outstanding debt obligations seems the most obvious, driven by the surge in debt creation prompted by low interest rates, which will require refinancing over time. This becomes highly problematic for the weakest hands at the table. A loss of confidence from markets tightens access to credit, leaving less financially robust borrowers exposed, generating a procyclical negative debt loop. This isn’t a matter of the borrower not liking the interest rate on offer to refinance; it pertains to lenders demanding full repayment upon maturity. In many cases, refinancing may not even be an option.

While markets obsess about the next potential 25 basis point move by central bankers and whether we’ve hit terminal rates or if minor adjustments are still on the horizon, these concerns matter little in comparison to changes in the total cost of funding. Markets are on the verge of the rebirth of material credit risk – something that was extinguished 15 years ago through the US government programs designed to crush volatility during the GFC.

As the credit cycle turns, markets will speed up considerably. Risk managers at investment banks will be less inclined to warehouse these risks for long against a weakening macro backdrop. If these securities cannot be redistributed to new buyers quickly, caution is warranted.

Risk managers will force these inventories to be cleared at lower prices, triggering a feedback loop of declining prices. These episodes, once they become disorderly, have generally required policy intervention to dampen the volatilities. The notion of “higher for longer” might mean it is a get down, stay down world for a little while yet. The one sure thing is that volatility will persist, and market sentiment might well swing from return on capital to return of capital. That’s quite a distinction. In an environment of elevated rates, credit stress tends to emerge, and, in that moment, the quality of assets in a portfolio will really become significant.