Bond market suggests “soft landing” for U.S.

With corporate bond spreads narrowing, the U.S. bond market appears to be calling for a “soft landing” for the U.S. economy, according to a report from Moody’s Investors Service.

The rating agency reported that corporate credit spreads have tightened significantly in the past week — signaling that markets remain confident in credit conditions, and in the fortunes of the overall economy.

For instance, it noted that the long-term average corporate bond spread to the 10-year U.S. Treasury dropped by a “whopping 19 basis points to 125 bps and slipped below a 12-month low of 139 bps.”

And, the long-term average industrial bond spread dropped by 20 bps to 105 bps over the past week, well below its 12-month low of 120 bps.

“Last time corporate credit spreads dropped to such low levels was in February 2018,” the firm said.

At the same time, high yield credit spreads, which spiked to over 500 bps amid turmoil in the U.S. banking sector in March, have dropped too, Moody’s noted.

“Despite monetary policy tightening worldwide, market participants see a high likelihood for a ‘soft landing,'” the firm said. “This has been underpinned by healthy corporate balance sheets, persistent strength in consumer spending, and a relatively low level of corporate defaults this year.”

Moody’s reported that the trailing 12-month global speculative-grade default rate rose to 4% at the end of July from 3.9% in June.

It continued to forecast that the rate will rise to 4.5% in December — putting it above the long-term average of 4.1% — and that the default rate will peak at 4.7% in March of next year, before coming back down to 4.3% by July 2024.

“The peak rate forecast was revised downwards from 5.1% previously due to July’s tightening in U.S. high-yield spreads and a downward revision in the high-yield spreads forecast for the second half of this year,” it said.

While the bond market is currently signalling an expected soft landing, Moody’s said the U.S. economy is still expected to slow in the coming quarters.

“This slowdown will constrain aggregate demand, putting pressure on corporate earnings and cash flows,” it said, adding that companies are also facing higher debt-service costs due to the rise in interest rates.

“Low-rated companies will continue to struggle to meet refinancing and liquidity needs as they contend with interest rate pressure, tight lending conditions, and worsening operating performance as the economy slows,” it said.

Moody’s forecasts that the U.S. Federal Reserve Board’s 25 bps rate hike in July was its last move in the current cycle, and that it will hold steady on rates in the months ahead, before it can start cutting rates in June of 2024.

“However, we now expect that the Fed will relax monetary policy more slowly than previously anticipated, cutting rates by about 25 basis points per quarter until reaching 2.75% by the fourth quarter of 2026 and 2.5% in 2027,” it said. “This shift reflects more persistent than anticipated inflation in early 2023 and ongoing labor market tightness, which have caused similar revisions to the FOMC’s projections.”

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.