The Federal Reserve is hyper-focused on combating inflation. In its June meeting, the Fed left the key benchmark interest rate unchanged and tentatively set only a single rate cut this year as inflation remains above its goal of 2%. But the delay has a price.
Consumers face sky-high borrowing rates under the current environment influenced by the Fed's fiscal policy. At the same time, the labor market is not as robust as it used to be.
But there's a silver lining: Experts remain optimistic that the market is set for a soft landing — buoying stocks, somewhat balancing out the adverse effects of higher rates on borrowers, and at least, for now, keeping a recession at bay.
"The market consensus is firmly in the camp of soft landing," said Ryan Osborn, co-head of structured assets at Columbia Threadneedle, adding that market views on the probability of a recession have oscillated over the past 18 months."We transitioned from parts of last year when people thought a harder landing was a higher probability to where we stand today."
The market's view of interest rates bears this out, too.
"When we think about real disruption in the economy, the longer we stay at elevated rates, the more we think that it increases the probability of a bad outcome. The tails of the outcome become a little bit fatter," Osborn said.
Threadneedle believes the risk of higher unemployment is more elevated than increasing rates, Osborn said, although they do not necessarily call for either event. Instead, they view them as two tail risk events that would be problematic for the consumer.
"We think that inflation will continue to work its way down even if it's been a bit stubborn, which is why we think it is a smaller tail event that the Fed will have rate hikes, " he said, adding that "while the labor market has been quite resilient, some elements of it are showing potentially some weakness."
Concerns about large-scale job losses might be overdone, said Selma Hepp, Corelogic's chief economist, who sees a greater chance of a soft landing. Despite the labor market's showing some weakness, other than that period in early 2023 where there were many layoffs in the tech sector, job losses have not materialized across the economy.
"There are pockets here and there, but it goes back to unemployment claims that have been steady with no significant spikes," Hepp said.
So what accounts for the drag in inflation? It is the housing component, Hepp said, a lag effect from the inflation in rents over a couple of years ago, and will take time to resolve.
"What is being captured in the inflation measure is something from over a year ago, and it's slowly waning off," she said. "There are many arguments made that we are already back to the two percent inflation level that the Fed is targeting if some of these oddities are taken out of the data."
The haves and the have nots
The double whammy of persistent inflation and high rates has put consumers under tremendous pressure. Not all consumers are created equal, however, as a bifurcation in the market has emerged between prime and subprime borrowers.
"The US consumer is managing the double effects of inflation and the higher-for-longer interest rates well, on the surface and in the aggregate. But then when you look closer, it's usually the borrowers who don't have a lot of buffers who are suffering right now," said Elen Callahan, head of research at the Structured Finance Association.
Callahan says this is currently the tale of two consumers.
"Inflation has not had a big impact on higher quality or prime and super prime borrowers with FICO scores of over 700," Callahan said. "With stable jobs and healthy reserves, prime borrowers are able to handle the steady escalation in prices. On the other hand, the borrowers who don't have deep pockets, who are usually renters dealing with 20-30 percent rent hikes, and who probably have less stable employment are feeling the effects of inflation."
There is a very strong correlation between credit performance and unemployment, evident through various economic cycles except during COVID because consumer payments were frozen at that time through payment forbearance and other COVID-related government policies. "For credit cards, it's almost a one-to-one relationship. If you see a one percent increase in unemployment, you'll see a one percent increase in credit card delinquencies and charge-offs," Callahan said.
Osborn said that the bifurcation between the haves and the have-nots became more evident about a year and a half ago. In the second half of 2022, borrowers with lower incomes and FICOs started to struggle. Delinquencies in the unsecured consumer loan
space, specifically subprime autos, exceeded levels seen in the global financial crisis. Prime borrowers did relatively well during that period. Osborn said their performance started to soften a little in the last nine months with delinquencies up to expected long-term averages or slightly above that.
Non-prime assets fuel concerns over ABS fundamentals
Regarding securitizations, underlying assets originated at the end of 2020 and throughout 2021 and 2022 performed poorly, mainly for non-prime borrowers. That comes as no surprise, since inflation hurts that group the most. In that period, the system was also flushed with liquidity, and lenders tried to grow their volume at the expense of underwriting standards. That combination of factors led to poor performance, particularly for subprime borrowers.
"Underwriters have tightened underwriting in the last six to nine months, improving performance in asset portfolios, absent a recession and re-ignition of inflation, those borrowers will perform better than they had in the prior couple of years," Osborn said. He clarified that there is not a very large subprime credit card market, and they tend to get more of their data on the auto side, but he believes this would apply to both.
Pulling away from the broader economy and looking at securitization trusts for credit cards and autos is a different story. Callahan explained there is a vast difference between credit card ABS performance and performance on the aggregate. The New York Federal Reserve has credit card 90-plus-day and serious delinquencies at around 10 percent. By contrast, the 90-plus-delinquencies in credit card ABS trusts in aggregate is less than one percent.
"The reason for the difference is credit card loans that are securitized are usually more seasoned, so they have a longer payment history. It's a different pool altogether and not reflective of the national pool of credit card loans. That's the same story for prime autos."
