Q4 2026 Credit Research Outlook Higher rates will test the resilience of the credit cycle
Higher interest rates are testing credit-market resilience. Strong earnings, healthy balance sheets and sound bank fundamentals remain supportive, but prolonged tightening and fiscal uncertainty increase refinancing and credit-quality risks.
Higher interest rates remain a key focus for credit investors. Nominal 10-year government bond yields have risen materially across major developed markets, but the drivers have not been uniform. In the United States, stronger economic activity, elevated nominal growth, artificial intelligence-related capital investment, persistent fiscal deficits and a higher equilibrium real interest rate have all contributed to the increase. In Europe, higher energy prices, renewed inflation concerns, expectations for additional monetary tightening and sovereign fiscal uncertainty have played a more prominent role. Across the globe, the ultra-low-rate environment that followed the global financial crisis is fading further into the past.
A central question is whether persistently higher rates will become a growing headwind for credit markets. To date, rising yields have not triggered broad deterioration in underlying credit fundamentals. Strong corporate earnings, resilient economic growth, healthy balance sheets and investor demand generated by elevated all-in yields have kept credit markets anchored. However, the longer rates remain elevated, particularly if central banks continue tightening in response to an energy-related supply shock, the greater the risk that higher borrowing costs will weaken investment, job creation, refinancing capacity and, ultimately, credit quality.
Why rates are higher
The credit impact of higher rates depends on the underlying driver. Increases tied to stronger growth and investment can support earnings, while those driven by fiscal risk, inflation expectations or higher risk premiums tighten financial conditions and erode debt-service and refinancing capacity.
Both dynamics are evident today. US nominal growth, artificial intelligence investment, credit demand and above-potential activity across developed markets support cash flows but also sustain inflation and elevated policy rates. Historically, US Treasury yields have broadly tracked nominal gross domestic product growth: a 5.5% rolling 10-year nominal growth rate implies an approximate 4.8% 10-year yield. This relationship suggests that current conditions are closer to normal than stressed, unlike the late 1970s and early 1980s, although the 10-year yield is nearing the upper end of its historical range relative to this relationship.¹
The risk is that large fiscal deficits, quantitative tightening, heavier sovereign issuance, artificial intelligence-related financing needs and higher energy prices keep real rates and risk premiums elevated. Credit remains resilient while nominal income and cash flow keep pace with funding costs; vulnerability rises if growth slows, refinancing needs accelerate or yields increasingly reflect fiscal and inflation risk.
Credit fundamentals have provided support for the most exposed segments of the credit markets
Corporate credit fundamentals are broadly supportive. Profits are strong, financial stress is contained and liquidity has improved relative to short-term liabilities. Short-term borrowing costs, the corporate financing gap and slower real final-sales growth warrant monitoring, but current evidence points to slower growth rather than a credit contraction.²
High-yield-rated (HY) corporations, which are most exposed to the rising cost of debt, are also on firmer footing than at similar points in this cycle, at least in aggregate. Second-quarter revenue for US HY corporations rose more than 10% year over year, and operating profit increased by more than 14%, the strongest growth in four years, with gains across rating cohorts and 14 of 18 industries. Aggregate leverage declined to approximately 4.5x, and interest coverage improved to greater than 4.0x, although both remain somewhat weaker than long-term averages.³
To be sure, the aggregate data conceal dispersion. Debt and interest expense continue to rise, 21% of issuers have coverage below 2.0x, and smaller private companies carry materially weaker leverage and coverage. Strong earnings are currently offsetting higher funding costs, but refinancing pressure could drive rapid deterioration among smaller, lower-rated borrowers if growth slows, consistent with a selective default cycle rather than systemic stress.
The policy risk: Tightening into a supply shock
A central risk to the resilient credit backdrop is that central banks tighten into an energy-driven supply shock. Higher oil prices lift inflation while eroding household purchasing power and corporate margins, and, after several years of above-target inflation, policymakers have less scope to look past the shock. Capital Economics estimates energy prices could add roughly 1.25 percentage points to advanced-economy headline inflation, keeping inflation near 3.5% to 4.0% in the United States, United Kingdom and euro area through at least the second quarter of 2027.⁴
Recent policy decisions highlight this tension. The European Central Bank raised its deposit rate to 2.50% and increased its inflation forecasts, while the Federal Reserve lifted its target range to 3.75% to 4.00% amid resilient growth and 6.3% year-over-year nominal consumer spending growth. Both moves indicate that policymakers are restraining demand despite a partly supply-driven inflation impulse. The credit risk is that policy remains calibrated to current nominal growth after underlying activity weakens.
Monetary tightening affects construction, investment, hiring, consumer credit and refinancing with a lag. Oil near $100 per barrel would create a stagflationary impulse and initially reinforce hawkish policy, but a more disruptive shock could ultimately halt tightening. One or two additional hikes appear absorbable, but a prolonged hiking cycle would raise the probability that financing costs outpace cash-flow growth, especially for leveraged borrowers, interest-sensitive consumers and issuers reliant on continuous market access.
Implications for the cash investment universe
As our readers know, the Global Cash investment universe is more concentrated in the obligations of large, systemically important banks and other highly rated financial institutions. The latest operating results and management commentary remain reassuring. Systemically important US, Canadian and European banks continue to benefit from resilient net interest income, loan growth, fee income, wealth management revenue and investment banking activity. Capital, liquidity and asset quality remain sound, providing significant capacity to absorb a weaker macroeconomic environment should one develop.
No broad-based emerging credit-loss category is currently evident across our bank investment universe. Asset quality remains a strong component of the credit profile, with consumer credit generally normalizing rather than deteriorating and commercial credit trends improving from a healthy base. Most recently, net interest income guidance was more frequently increased than reduced, and deposit franchises continued to fund loan growth without material reliance on higher-cost wholesale markets.
Higher rates can continue to support bank earnings, but the benefit has limits. Many banks remain asset-sensitive, so modest additional increases should bolster net interest income. However, rising deposit betas offset some of this benefit as funding shifts toward interest-bearing deposits and certificates of deposit. More importantly, management teams have warned that further hikes could weaken loan demand; one US bank identified three additional increases as the threshold for material loan-demand headwinds. Thus, near-term earnings may remain supported even as the risk of a subsequent slowdown rises.
The principal bank-specific watch items are therefore not current asset quality or liquidity. They are the quality and sustainability of earnings, the gradual movement toward more expensive deposit funding and, in the case of major US banks, the normalization of capital targets based partly on regulatory relief that is not yet final. Management teams are increasingly planning to operate with less excess common equity capital while continuing buybacks and balance-sheet growth. This does not presently undermine the credit profiles of the major Cash investment counterparties, but it increases the importance of distinguishing institutions with diversified earnings and deep deposit franchises from those more dependent on spread income or optimistic regulatory outcomes.
Outside the US, Canadian banks delivered strong results, including broad consensus beats, positive earnings revisions and double-digit pretax, pre-provision earnings growth outside capital markets at most institutions. Commercial lending accelerated, credit trends improved, and stable capital, ample liquidity and excess capital provided meaningful downside protection. Key risks are whether loan growth maintains pricing and underwriting discipline, deposit growth keeps pace and mortgage losses remain contained amid Canada-US trade uncertainty.
European bank results have been similarly uneventful from a creditor perspective, supported by loan growth, net interest income, hedging, wealth management fees and investment banking revenue. Strong capital generation provides a buffer against normalized losses and distributions, although elevated valuations, reliance on capital markets activity and limited management concern warrant caution as rates rise. European sovereign risk remains an additional vulnerability: weak growth, persistent fiscal deficits and wider spreads could pressure domestic funding, securities valuations, confidence and banks’ cost of capital. French banks are particularly exposed to a material widening in French sovereign spreads, but their current operating profiles remain sound, supported by strong earnings, capital, liquidity and diversified businesses.
For our credit process, the appropriate response to these types of risks is continued issuer-level differentiation. We will monitor sovereign spread behavior, the progress of fiscal policy, the effect of sovereign yields on bank securities portfolios and any evidence that political or fiscal uncertainty is affecting deposits, wholesale funding or capital markets access. If those risks begin to alter individual bank credit profiles, our primary risk-mitigation tool remains the ability to reduce permitted maturities while preserving access to fundamentally strong counterparties.
Concluding thoughts
We have described credit conditions as late-cycle for an extended period, and the cycle has continued longer than many investors expected. It reflects the durability of nominal growth, strong corporate profitability, substantial capital markets liquidity and the ability of companies and banks to adapt to a higher cost of capital.
Nevertheless, vulnerability is pronounced because valuations and policy leave limited room for error. Higher rates are manageable when they reflect stronger growth and earnings. They become increasingly unfriendly to credit markets when they persist after activity and employment weaken, when refinancing costs rise faster than cash flows or when the increase is driven by fiscal and inflation risk rather than productive investment.
We continue to believe that credit spreads are vulnerable to widening from historically compressed levels. A repricing would not necessarily signal a systemic credit event. It would more likely reflect a normalization in compensation for macroeconomic uncertainty, policy risk and the uneven effect of higher borrowing costs across issuers. The most exposed areas remain highly leveraged borrowers, smaller private companies, issuers with limited refinancing flexibility and sectors where earnings are insufficient to absorb higher interest expense.
For the Global Cash investment universe, the risk outlook is more constructive. The large, systemically important banks that comprise the core of our approved investment universe are entering a potentially weaker environment with strong capital, abundant liquidity, diversified earnings and sound asset quality. These institutions are not immune to slower growth, sovereign market volatility or stress among leveraged borrowers. However, they have sufficient financial capacity to absorb meaningful deterioration without materially weakening their short-term credit profiles.
As cash investors, our objective is not to predict the precise end of the credit cycle. It is to ensure that the approved credit universe and associated maturity restrictions remain appropriate across a range of outcomes. Higher rates, tighter monetary policy and sovereign fiscal concerns warrant vigilance. They do not presently warrant a broad change in our assessment of the strongest global banking counterparties. We remain prepared to shorten maturities where issuer-specific risks increase while maintaining confidence that the high-quality institutions in our Cash investment universe are positioned to withstand a more challenging credit environment.