LIBOR Transition Creates Uncertainty for SF Market

Replacing LIBOR presents challenges for the structured finance (SF) market that are likely to be addressed in the context of industry-wide initiatives, Fitch Ratings says.

The long lead time and a desire to avoid disruption to floating-rate bond markets such as SF should support the transition to standard benchmarks as successor reference rates. The impact on SF will depend on which rates are adopted, how consensual the process is across all market participants, and how they deal with technical and administrative challenges.

LIBOR is the reference rate for SF bonds and related derivatives contracts in several large SF markets. Almost all of the USD450 billion of US CLO notes outstanding reference LIBOR, as do USD186 billion of US sub-prime/Alt-A RMBS and USD24 billion of US prime RMBS. US student loan ABS commonly reference LIBOR. Elsewhere, nearly all UK RMBS reference Libor. Some underlying loans, such as leveraged loans, US hybrid adjustable-rate mortgages, US student loans, and auto loans, reference LIBOR.

Panel banks will maintain LIBOR until end-2021. This gives capital markets four-and-a-half years to agree a successor regime for the bulk of bonds currently linked to LIBOR, enabling a coordinated transition to as few benchmarks as needed. This would avoid costly ad hoc negotiations and potentially complicated bespoke transaction amendments. Loan markets may follow suit, although the risk of fragmentation geographically and by asset class could create SF basis risk in respect of existing loans, or alter the level of credit-enhancing excess spread.

There are practical challenges in co-ordinating transition. Voting rights in SF transactions, in some cases requiring majority consent of all classes of notes, may complicate any amendment process and even increase the scope for inter-creditor disputes. Trustees will also have an important role in determining what conditions are placed on transaction parties. These challenges will require effective use of the long lead time available.

To preserve liquidity, we think bond markets will generally follow initiatives in the derivatives market, where funding is hedged and discount rates determined. The International Swaps and Derivatives Association is examining fall-back provisions in LIBOR swap contracts, and working groups in some jurisdictions have recommended alternative near-risk free reference rates for the derivatives market, including the Sterling Overnight Index Average (SONIA) in the UK and the Broad Treasuries Repo Financing Rate in the US.

But it remains unclear whether the eventual successors to LIBOR will be overnight rate benchmarks or forward rate benchmarks, how far this will vary from country to country, and whether loan markets will adopt the same reference rates at the same time (reducing basis risk). At the heart of these questions is the effect on the value of currently contracted interest payments.

Any move to replace LIBOR with a benchmark that increased interest costs, particularly for retail borrowers, would face political objections. But a reduction in interest earned could also face opposition. Balancing these interests may prompt efforts to adjust margins to leave loan and bond coupons unchanged. Challenges coordinating the transition for assets and liabilities could leave SF transactions with basis risk, or change the level of excess spread. Possible consequences for ratings would also depend on the weighted average life remaining after 2021.

Commercial borrower behaviour may contribute to these risks. For example, some commercial real estate and leveraged loans include fall-back provisions aimed at managing temporary disruptions in LIBOR determination (such as polling a small panel of banks). These could make it harder to co-ordinate the transition for underlying loans and SF bonds, particularly in the leveraged loan market.

Unlike floating-rate commercial mortgages, leveraged loans are typically not hedged against interest rate risk, and may have more latitude in diverging from standardised successor benchmarks emerging from the derivatives market. If leveraged loan borrowers felt it was in their commercial interests to argue that fall-back provisions apply, basis risk would arise if CLOs moved to more liquid successor benchmarks.

China’s Cooling Housing Market Set to Weigh on Economy

China’s housing market is likely to continue to cool in response to stronger restrictions on home purchases across many cities and tighter credit conditions, say Fitch Ratings. Housing is the key cyclical sector in the Chinese economy, and will weigh on growth in the second half of the year and into 2018.

There is already evidence that the housing market is slowing. Growth in new residential property sales decelerated to 24.0% yoy (on a trailing 12-month basis) in May 2017, down for the fifth straight month from the 36.2% peak in December 2016. Price gains have also moderated. Secondary home prices in Tier 1 cities rose by 28.7% in 2016, but increased by just 3.6% in the first five months of 2017, and fell for the first time since September 2014 in May.

The downturn has been policy driven, with the authorities stepping in to prevent excessive froth in the market. Tightened rules on home purchases and mortgages are curbing buying by speculators and upgraders. Some first-time buyers might also be postponing purchases in the expectation that prices may fall. Meanwhile, the increased focus of the authorities on controlling leverage and limiting financial risks has led to a significant rise in money-market interest rates since last December, and some banks have recently increased mortgage rates.

The near-term outlook for China’s housing market is closely linked to the domestic credit cycle. As the chart below shows, housing sales move broadly in line with the “credit impulse” – or the change in the flow of new credit (including local government bonds) as a share of GDP. A weaker credit impulse, along with the tightening of home purchase restrictions, is likely to drag down home sales growth further in 2H17.

That said, the government will want to avoid causing significant volatility in the market. Home sales dropped by 9% yoy in early 2015, following the last tightening of restrictions, which contributed to a strong release of pent-up demand when policies were subsequently relaxed. We expect a more cautious approach this time, which is likely to result in home sales stalling, but not falling, in 2H17.

House prices are likely to decline slightly in 2H17, as demand weakens. We expect prices in Tier 1 cities to hold up better than in lower-tier cities. Prices in Tier 1 cities have risen by almost 90% in the last four years, compared with increases of 10%-25% in lower-tier cities. However, demand in Tier 1 cities remains strong and land supply is tight, which gives the authorities more scope to support the market if the downturn is sharper than expected. In lower-tier cites, demand is weaker and developers’ housing inventories are higher.

A likely weakening in the housing market is one of the main reasons behind our forecast that GDP growth will slow in 2H17. Investment in housing alone accounts for around 10% of GDP, and most estimates place its contribution to GDP much higher once supporting industries are included. There tends to be a six- to eight-month lag from sales to housing investment growth, which means that the economic impact of the housing market slowdown will continue well into 2018, when we expect GDP growth to slip slightly below 6%.

Medium Term Growth Potential Still Below 2% in Advanced Economies

Recent improvements in the near-term growth outlook for the advanced economies are not expected to be sustained over the medium-term, says Fitch Ratings in a new report.

“While we have become more optimistic about advanced country growth prospects in 2017 and 2018, our latest assessment of medium-term growth potential suggests that this year and next could be more or less as good as it gets,” said Brian Coulton, Chief Economist at Fitch.

New projections of supply-side potential GDP growth for the advanced economies covered in Fitch’s Global Economic Outlook (GEO) suggest underlying growth performance over the next five years will lie in the 1.25% to 1.75% range for most of the 10 advanced GEO countries. The demographic outlook is set to deteriorate further and we do not see a major turnaround in productivity performance after the slowdown witnessed over the last decade or so.

Nevertheless rising labour force participation rates – as more women enter the labour force and more “over 65s” stay in jobs or return to work – give some grounds for encouragement from recent supply-side performance. Furthermore, Germany’s success in reducing structural unemployment since the mid-2000’s shows the benefits to potential GDP that can accrue from labour market reforms.

US potential growth is projected at 1.8% p.a. This compares with long-run historical average growth of just below 3%, with the deterioration primarily reflecting demographics. UK potential growth is estimated at 1.7% relative to long-term average GDP growth of 2.2%. A structural slowdown in UK productivity over the last decade is only expected to be partially reversed. Potential growth for Germany and France is similar at around 1.2% but the mix differs markedly with a better outlook for productivity in Germany offsetting significantly worse demographics. Spain’s potential growth is in a similar range even though it has recently seen significantly faster actual growth.

Australia is expected to see the best supply-side performance over the next five years with potential growth of 2.4%, reflecting strong population growth and healthy labour productivity. At the other end of the scale, potential growth in Japan and Italy is projected at just 0.7% and 0.4%, respectively. Demographics weigh very heavily in Japan although this is partially offset by surprisingly robust productivity. Italy has, however, seen persistently falling productivity levels over the last 10 years.

The scope for growth to exceed supply-side potential rates over the medium-term as economic slack is absorbed is also limited. Output gaps – ie the shortfall in the level of actual GDP from potential GDP – are estimated to have been modest in 2016 for most advanced countries and with 2017 growth generally forecast to be faster than potential, they are narrowing. Only in Spain and Italy is the current negative output gap judged to be large enough to expect actual growth over the next five years to materially exceed its estimated supply-side potential rate.

Fed Heading for Faster-than-Expected Normalisation

The Federal Reserve hiked its benchmark rate hike this week. Judging by their associated comments, Fitch Ratings says this reinforces the view that U.S. interest rates will normalise faster than financial markets expect.

The Fed on Wednesday raised the fed funds target rate for the third time in seven months, to 1.00%-1.25%. The Fed also announced that it expects to start phasing out full balance sheet reinvestment in 2017 and provided details on the modalities of doing so.

The rate increase and accompanying comments bolster our view that the fed funds rate is likely to normalise at 3.5% by 2020, and U.S. 10-year bond yields will rise back above 4%. These developments would mark a significant shift in the global interest rate environment.

Fitch believes the Fed is increasingly comfortable with its normalisation process and less data-dependent following recent inflation readings that have been slightly lower than consensus expectations (although they remain close to target). The interest rate hike showed the Fed was prepared to look through weak first quarter consumption and GDP and underlines Fed concerns about unemployment falling too far below its equilibrium rate. .

Our fed funds rate forecasts also reflect scepticism regarding the idea that the equilibrium (or “natural”) U.S. real interest rate has fallen close to zero. We think the fall in actual real rates is explained by the slowdown in potential GDP growth driven by demographics and weaker productivity growth, and by an elongated credit and monetary policy cycle. As this extended credit cycle comes to an end, Fitch believes the Fed will set rates according to its view of the U.S.’s long-term potential growth rate and its inflation target. This suggests the equilibrium nominal fed funds rate would be 3.5%-4% if real rates normalise in line with our estimate of U.S. potential growth at slightly below 2%.

The impact on bond yields will also be determined by how far the term premium rises from the current historically low level partly caused by the Fed’s Quantitative Easing (QE) programme. The Fed’s approach to balance sheet normalisation sees reinvestment only to the extent that maturities exceed pre-set caps. The caps will initially be set at low levels but will rise to maximum levels of USD30bn per month for Treasuries and USD20bn per month for agency debt and mortgage-backed securities. A return to a positive term premium of 50bp-100bp as the QE programme is unwound would see long-term U.S. bond yields normalise at 4%-5% given our estimates of the equilibrium Fed Funds rate.

Biggest Threats to Dollar’s Global Supremacy are at Home

From FitchRatings.

The US dollar will almost certainly remain the world’s most important reserve currency for the foreseeable future, as no other offers the same set of advantages to money managers, including central banks, or is as deeply embedded in the global financial system. The primary cost to the US is surrendered competitiveness due to dollar appreciation, but lower interest rates and unrivalled government access to funding bestow considerable benefits, ultimately supporting the sovereign’s ‘AAA’ rating.


The dollar dominates global bond markets, central bank foreign reserve holdings, international trade invoicing and cross-border lending. It is the standard currency used for commodity and other prices, and is the preeminent safe-haven asset and preferred store of value in times of financial turmoil. Crucially, the dollar is underpinned by the fact that the US Treasury market is the world’s largest and most liquid for risk-free assets, and the Federal Reserve operates independently of government with respect to the market, and in implementing policy more broadly.

The dollar’s role is so widespread that its supremacy is self-reinforcing. The additional costs and/or inconvenience of switching to another currency for transactions normally conducted in dollars create a high degree of inertia, making it difficult for other currencies to gain traction.

Calls for the dollar’s displacement were relatively infrequent — though not entirely absent — when US monetary policy was exceptionally accommodative in the aftermath of the global financial crisis. That changed in mid-2013 when the Federal Reserve announced it would begin to slow its asset purchases, causing considerable turmoil in emerging markets (the “taper tantrum”) and appeals to the Fed for greater consideration to be given to the international implications of its policy decisions.

The Fed now appears poised not only to continue with policy interest rate hikes that began in December 2015, but also to consider the pace and magnitude of eventual balance-sheet reductions. Dollar funding is already costlier in markets outside the US, and has been for several years, as reflected in elevated cross-currency basis spreads for several currencies versus the dollar. If they rise further, as they may when Fed balance-sheet reduction draws nearer, there will again be concerns about global stresses associated with Fed tightening and inevitable suggestions that the dollar’s hegemony be somehow curtailed.

Realistic, immediately available alternatives to the dollar are limited. It is important to note, however, that the dollar is not alone either as a reserve currency or in many of its other global roles; it is just the biggest player. Other recognised reserve currencies (tracked by IMF data) are the euro, Japanese yen, pound sterling, Swiss franc, Australian and Canadian dollars
and Chinese renminbi.

In most instances, financial markets in countries that have reserve currencies are far too small to pose a threat to the dominance of the dollar. The most obvious candidate to replace the dollar is the euro, given the size and depth of euro-denominated capital markets as well as the credible focus of the European Central Bank on controlling inflation. However, for at least as long as the currency zone is plagued by lingering existential risks amid questions over possible member withdrawals, it will not be in a position to overtake the dollar. The renminbi is growing rapidly in trade settlement, but neither it nor the yen offer truly risk-free assets given their sovereign ratings, and China seems some distance from having an open capital account and fully internationalised currency even if it were rated higher.

The lack of a ready substitute, however, does not mean the dollar’s current position is entirely assured. Perhaps the most plausible scenario for the dollar being meaningfully displaced does not begin with the emergence of a viable alternative, but rather it being undermined at home.

Two pieces of legislation currently working their way through Congress are the Federal Reserve Transparency Act (FRTA) and the Financial Choice Act (FCA). The first would allow the Government Accountability Office to audit the monetary policy decisions of the Fed and make subsequent recommendations for administrative or legislative actions. The second would restrict the Fed’s ability to provide financial sector support to avert or address a crisis, and empower a commission to review and recommend changes to the Fed’s operations, as well as to consider a rules-based rather than discretionary monetary policy framework.

It is the unambiguous intention of these legislative initiatives to curtail the independence of the Fed and allow for greater congressional oversight of monetary policy as well as the Fed’s regulatory decisions and interventions related to financial stability. If implemented, the proposals would diminish the appeal of the dollar as a reserve currency over time. Investors
considering dollar assets and other dollar exposures would weigh the risk of political interference in monetary policy decisions and the possibility of the Fed’s remit being broadened to include congressional priorities such as indirect funding of infrastructure investment. There may also be concerns about episodes of financial sector stress being deeper and more prolonged if the Fed’s policy response options were explicitly limited.

Parties in favour of the FRTA and FCA might argue that the risks identified by those concerned about the Fed’s independence — and, incidentally, the dollar’s global role — are, in fact, the purpose of the proposed legislation, and that the overall economic interests of the US would be better served by their implementation. The debate is unlikely to end soon no matter the fate of the FRTA and FCA. Either way, the dollar is set to remain the world’s most important reserve currency, a position it is likely to hold for some time.

U.S. Bank Deregulation Advances, But Hurdles Remain

The momentum for U.S. bank deregulation continues to grow, but it is becoming more likely that it will take the form of multiple smaller bills targeting relief for specific segments of the financial sector as opposed to a single, comprehensive bill, says Fitch Ratings.

The Financial Choice Act (FCA) remains the benchmark for the full deregulation agenda given the upcoming House vote on a revised version that was passed by the House Financial Services committee earlier this month. The updated version (FCA 2.0) is mostly in line with the original bill from 2016 and still calls for the full repeal of the Volcker Rule, the Orderly Liquidation Authority (OLA) and the Department of Labor (DOL) Fiduciary Rule.

Broad and deep deregulation is generally viewed by Fitch as likely to have a negative impact from a bank credit risk perspective; however, the ultimate form of regulatory change and its application by individual banks will determine the ratings implication.

A repeal of Volcker is unlikely to result in banks’ returning to full-scale proprietary trading, but it could carry negative rating implications depending on banks’ response. The elimination of OLA could expose the banking sector to significant systemic risk in the event of a crisis, though resolution planning could be a mitigating factor to large bank failures. While eliminating the DOL Fiduciary Rule would likely benefit banks’ wealth management businesses and asset managers’ profitability, reputational and litigation risks would remain.

Key differences between FCA 2.0 and the original bill include simplifying the threshold for banks to opt out of most regulations, changing operational risk weights for global systemically important banks (G-SIBs), replacing the Consumer Financial Protection Bureau (CFPB) and relaxing some components of stress-testing.

Fitch does not believe proposed changes to the CFPB would directly affect most banks’ and non-bank financial institutions’ credit profiles, though they could reduce the regulatory burden and associated costs. Further revision to bank stress testing as proposed under FCA 2.0 is likely to be ratings neutral.

Global Growth Recovery on Track

The pick-up in global growth remains on track, with disappointing first-quarter US GDP data offset by better-than-expected numbers in China, and sustained growth in the eurozone and Japan, says Fitch Ratings in its Global Economic Update report.

“Weaker 1Q US growth was explained by consumption and looks to have been affected by temporary factors. Falling unemployment, wealth gains, improved consumer confidence and the prospect of income tax cuts should support a recovery in consumption from 2Q17. In China, the impact of earlier policy stimulus on activity has proved more powerful than anticipated and the slowdown in the housing market has taken longer to materialise than expected,” said Brian Coulton, Fitch’s Chief Economist.

The resilience and breadth of the eurozone recovery continues, with the region posting its eighth consecutive quarter of steady growth at an annual pace of 1.5%-2%.

“Rising bank credit to the private sector and strengthening housing markets suggest accommodative monetary policies are gaining traction in the eurozone, while a mild easing of fiscal policy since 2015 and strong job growth have also helped,” added Coulton.

Fitch expects world growth to rise to 2.9% in 2017 from 2.5% in 2016 and has slightly revised up its 2018 forecast to 3.1% from 3.0% in March. The US growth forecast for 2017 has been revised down slightly but this has been offset by a better outlook for China and Japan.

U.S. Bank Loan Losses to Rise as Loan Growth Halts In 1Q17

Quarterly earnings generally improved for U.S. banks in the first quarter of 2017, but loan growth came to a halt and loan losses are likely to increase over the near to medium term, according to Fitch Ratings’ U.S. Banking Quarterly Comment. Provision expenses for the 18 largest U.S. banks covered in the report rose 8% in 1Q17 from 4Q16 and loan losses in nominal terms increased on a linked-quarter basis. Growing concern in asset quality, particularly in credit cards, auto, and retail loan exposure from the disruption of e-commerce could contribute to increased loan losses going forward.

“Better capital markets results, lower taxes from new accounting guidance and modest improvement in spread income boosted earnings for the majority of U.S. banks, however, loan growth came to a standstill, expenses and credit costs climbed and mortgage revenue slowed during the quarter,” said Julie Solar, Senior Director, Fitch Ratings.

Overall industry-wide loan balances declined 2.5% on an annualized basis. For the large U.S. banks, this trend was less pronounced, with total loans down approximately 0.8% on an annualized basis. Pay-downs in energy credits, large corporate borrowers accessing the capital markets, discipline in maintaining risk-adjusted returns, and seasonally lower credit card balances all contributed to the decline in loans. Many borrowers are also waiting for more definitive policies from Washington despite improving business optimism before borrowing.

“Looking ahead, loan growth will be dependent on continued economic growth and will vary by loan category particularly with concerns in auto and signs that banks are demonstrating greater commercial lending discipline,” said Joo-Yung Lee, Managing Director, Fitch Ratings.

Twelve of the 18 banks reported higher net income in 1Q17 than in 4Q16 and several banks reported increases in net interest margins (NIM) including M&T Bank, Bank of America, Fifth Third Bancorp, and BB&T. The better NIM is largely due to the December 2016 interest rate increase as the March rate rise came too late in the quarter to materially impact the results. Capital markets results for the five large global trading and universal banks increased 19% in aggregate from 1Q16, with most of the improvement in equity and debt underwriting, up 92% and 51%, respectively, from the prior year.

In addition, several banks benefited from one-time tax benefits from the adoption of new stock-based compensation guidance. Goldman Sachs saw a large benefit witch the change accounting for 21% of its income. The new guidance is expected in impact first quarter results going forward.

Bank capital ratios remain solid with a median CET1 of 10.8% at March 31, 2017. Commentary from banks indicates that capital distributions will increase across the industry.

Housing Slump & Eurozone Key Australian Investor Concerns

High household debt and further strong house-price gains are fuelling Australian investor’s concerns around a domestic housing-market downturn, according to Fitch Ratings’ latest survey of the country’s fixed-income investors. Investors also believe developments in the Eurozone now pose a greater risk to Australian credit markets than a China hard landing.

The 2Q17 survey was undertaken in partnership with KangaNews – a specialist publishing house that provides commentary on fixed-income markets in Australia and New Zealand. Findings represent the views of managers of more than AUD300 billion of fixed-income assets, accounting for over three-quarters of Australia’s domestic real-money market.

Australia is facing mildly tougher economic conditions according to fixed-income investors. Their outlook for three key economic indicators suggests the next three years will see modest interest rate increases, a drift to slightly higher unemployment and house price declines. Interestingly, 60% of investors expect house prices to rise by between 2% and 10% by end-2017, while 52% expect house prices to decline by between 2% and 10% by end-2019.

Investors believe banks are better placed to manage risks, despite their less-than-rosy economic outlook, following steps taken to strengthen bank balance sheets and tighten lending standards. Property market exposure remains investors’ key concern, but the proportion ranking it as ‘critical’ has dropped to 30%, from 43% in our previous 4Q16 survey.

Corporate Australia’s credit profile is also expected to strengthen, with more investors taking the view that corporates will deleverage. The proportion of investors expecting corporate leverage to decrease has risen to 23%, from 4%, over the three surveys conducted over the past twelve months. Investors have nominated the corporate asset class as their preferred investment choice.

Australian investors anticipate a strong rebound in structured finance RMBS and ABS issuance over the next 12 months. Fifty-eight percent believe there will be increased issuance in 2017, up from just 16% in our 4Q16 survey.

Significant Shift in Global Interest Rate Environment Ahead

Borrowers should prepare for a significant shift in the global interest rate environment in the next few years, Fitch Ratings says. Fitch expects US real interest rates to increase to levels that are more closely aligned with US economic growth potential.

“With the Fed having now achieved its inflation and employment objectives, becoming more focussed on the risk of labour market tightening and starting to discuss the unwinding of its balance sheet, we expect interest rate normalisation will take place by 2020 and that the Fed Funds rate will reach 3.5% to 4%,” said Brian Coulton, Chief Economist at Fitch.

This estimate is above the Fed’s current “DOTS” projection for the long term and substantially higher than current financial market expectations for US rates in three years’ time. It would also imply a sizeable upward shift in bond yields to the 4% to 5% range as long-term expectations for the Fed Funds rate adjust.

The fall in US real interest rates (i.e. nominal rates adjusted for inflation) has been one of the most striking macroeconomic trends over the last decade or so and has gone well beyond what can reasonably be explained by shifts in economic growth or inflation performance.

One school of thought puts this shift down to long-term fundamental changes in the real economy that have boosted the supply of savings at the same time as the demand for funds for investment has diminished. Demographic changes, rising inequality and an emerging market (EM) savings glut are claimed to have pushed out the supply of savings, while lower public investment, falling capital goods prices and an increase in the risk premiums required for private investment projects are seen as having driven down investment demand. The fall in real rates is seen as a lasting shift to a new ‘equilibrium’, where the relative price of savings is permanently lower and real interest rates are unlikely to rise much above zero per cent even over the medium to long term. This view appears consistent with market expectations that the nominal Fed Funds rate will not increase much beyond 2% – i.e. in line with the Fed’s inflation target – even by 2020.

However in Fitch’s view, this conclusion does not look robust. US saving rates actually fell as the working age share of the population increased after 2000 and Fitch’s calculations suggest that the increasing share of the top quintile in total household income (a group which has higher saving rates than average) is unlikely to have significantly raised the aggregate saving ratio. Financial linkages between the US and EM are weaker than those with other advanced countries and EM current account surpluses and FX reserve accumulation have fallen since 2014 without prompting a correction in US real rates. Public investment has fallen to historical lows but there could be upward pressure over the medium term. The relative price of capital goods has been broadly stable since the mid-2000s. Finally, rising risk premiums can just as easily be explained by distortions to government borrowing rates from central bank Quantitative Easing polices as by increased hurdle rates for private investors.

An alternative view sees current exceptionally low real rates as the outcome of an elongated credit cycle whereby commercial bank and central bank actions have driven real rates away from equilibrium for an extended period. The narrative that accompanies this view highlights loose monetary conditions in the US in the early to mid-2000s, which set the scene for aggressive credit creation and risk pricing by commercial banks. These conditions contributed to the sub-prime crisis, which then saw central banks loosen monetary policy aggressively to minimise the impact of the crisis on the real economy. This view implies that real rates will revert to more normal levels – more closely aligned with economic growth – once the credit cycle has played out. Fitch sees considerable intuitive appeal in this characterisation.

A crucial question is where the economy lies in the current credit cycle. This boils down to the capacity of the US economic recovery to withstand higher interest rates. Aggregate macroeconomic data on debt burdens suggest that it can. The US household debt to income ratio has fallen to early 2000s levels, household debt service ratios are at record lows and the interest-coverage ratio for the US corporate sector in aggregate is at a multi-decade high.

“If the credit cycle view of US real rates is correct and if the cycle is nearly over, the implication is that nominal US interest rates will adjust quite sharply in the next few years,” added Coulton.

Fitch’s assessment of US potential real GDP growth is around 2%, which would imply a real Fed Funds rate of 2% or slightly below. Given the Fed’s inflation target of 2%, this would imply a nominal Fed Funds rate of 3.5% to 4.0% once the current cycle has ended and rates have normalised.