The Transmission Mechanism of Monetary Policy

Balance sheets with higher debt, lower earnings, and lower savings will get hit first by Fed hikes, both for consumers and firms, see the first chart below. As this process continues, Fed hikes will gradually impact higher-quality balance sheets over time.

Once the Fed funds rate reaches sufficiently restrictive levels, the macro data will weaken. This is happening now: Delinquency and default rates are increasing for more vulnerable households and firms, and capex spending and nonfarm payrolls are weakening, see the second and third charts below.

This is how monetary policy works, and markets should expect the economic data to weaken further over the coming months as Fed hikes gradually bite harder and harder on consumers and firms.

Source: BLS, Haver Analytics, Apollo Chief Economist

Source: Census Bureau, Bloomberg, Apollo Chief Economist. Note: Capex spending is real capital goods orders nondefense ex-aircraft deflated by private capital equipment PPI.

US Consumers Want to Travel

The Conference Board’s consumer confidence survey asks households if they plan to travel to a foreign country, and the first chart below shows that a record-high share of US consumers are planning to go on vacation to a foreign country within the next six months.

The continued strong demand for consumer services is the reason why it is so difficult for the Fed to get supercore inflation under control. US households want to travel on airplanes, stay at hotels, eat at restaurants, go to sporting events, amusement parks, and concerts, and that is why inflation in the non-housing service sector continues to be so high, see the second chart.

The bottom line is that rates will stay higher for longer because the Fed is not succeeding with getting non-housing service sector inflation under control.

Source: The Conference Board, Haver Analytics, Apollo Chief Economist

Source: BEA, Haver Analytics, Apollo Chief Economist

Employment Keeps Slowing

Since our last edition of the Weekly Brief, we’ve had one critical piece of data: the August employment report. It showed that the US economy generated 187,000 jobs with downward revisions for June and July. These numbers represent a continued cooling in employment growth as the Federal Reserve continues to raise interest rates. Looking ahead, the consensus is expecting the slowdown in employment to continue into at least the first quarter of 2024, potentially dipping down to as low as 12,000 jobs created per month by March. This is an important downside risk that we are closely watching as the Fed continues its ongoing work to lower inflation.

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Outlook for Public and Private Markets

Our monthly outlook for public and private markets is available here.

Fed hikes continue to push delinquency rates higher on credit cards and auto loans.

Also, Fed hikes continue to push higher default rates for HY and loans. And interest coverage ratios are moving down for both IG and HY.

The bottom line is that higher interest rates are biting harder and harder on consumers and firms, and the Fed’s ongoing efforts to cool down the economy will continue. There are more downside risks than upside risks to markets, see overview below.

ICR Declining for IG and HY

Interest coverage ratios are declining for investment grade and high yield companies, see charts below.

This is how monetary policy works. Higher interest rates lower earnings and increase debt servicing costs.

With the Fed on hold until the middle of next year, the weakening of corporate balance sheets will continue.

The downside risks to the economic outlook are intensifying with falling interest coverage ratios combined with rising consumer delinquency rates, households running out of excess savings, and student loan payments coming back.