U.S. banks are doling out fewer loans to businesses as lending standards tighten and demand weakens after 11 interest-rate hikes by the Federal Reserve, suggesting that economic growth could slow as credit contracts.

The volume of commercial and industrial loans that banks dish out to companies shrank by about 0.2% in September, marking a sixth straight month of declines, according to the Fed’s latest batch of H8 data. The extended stretch of declines is spurring some market watchers to fret that the economic deceleration the Fed has been trying to engineer to curb inflation is now closer on the horizon, and may turn out to be quite painful.

Less borrowing often reflects declining investments by businesses and a fall in hiring activity, which in turn weighs on economic growth.

“A slowdown in lending is starting to bite the economy,” said Matt Eagan, portfolio manager and co-head, Full Discretion Team, at Loomis Sayles & Co. “We are starting to see corporations signaling about weaknesses in consumption. Forward looking guidance is not so rosy.”

The fears come just as the U.S. stock market finished its best week in nearly a year, while the distress ratio for riskier companies is below the post-global financial crisis average and spreads on U.S. investment-grade bonds have barely budged. 

But that risk-on mood is no longer sustainable. 

Over the next 12 months, U.S. high-yield bond and leveraged loan issuers are expected to default at rates of 8% and 7.6%, Hans Mikkelsen, TD Securities’ managing director of credit strategy, wrote in a Monday note. The average default rate for the two asset classes going back to 1996 is 4.6% and 3.3%, Mikkelsen said.

He also points out that while the net share of banks tightening lending standards for medium- and large-sized firms fell to 33.9% in the third quarter from 50.8% in the previous quarter, per the Fed’s latest loan officer survey, that figure is still historically high.

Meanwhile, corporate share buybacks and dividends are down 5% year-over-year through the second quarter, according to a JPMorgan Chase & Co. report Tuesday. “This is evidence that higher rates are having their logical intended impact on corporate balance sheets,” strategists led by Eric Beinstein wrote. Companies are shifting to more equity—by buying back or paying out smaller amounts—and less debt on their balance sheets, they noted. 

Businesses on weaker financial footing will be more vulnerable to a possible economic downturn. The riskiest borrowers are being choked off from access to credit, while investment-grade firms and higher-quality speculative-grade issuers are still enjoying access to the markets, albeit at higher rates.

Issuance has remained robust among blue-chip borrowers and higher-rated junk issuers, while U.S. leveraged loan sales are down roughly 27% year-over-year, Bloomberg league table data shows. Issuance from CCC rated firms—the weakest borrowers—is down on the year.

“You’ll start to see the economy slow down,” said Joe Kalish, chief global macro strategist at Ned Davis Research. “It’s just taking a while to filter through the economy.” He adds that overall loan growth is “pretty anemic.”

Signs of Slowdown
The Fed’s latest survey of senior loan officers at banks, known as SLOOS, showed that respondents saw tighter standards and weaker demand for C&I loans to firms of all sizes during the third quarter. The quarterly poll offers a broad window into the state of the credit market, and has been a keenly watched indicator of the health of U.S. lenders since the string of regional bank collapses in March. 

The weaker loan demand is being driven by fewer investments in plants or equipment, a decline in financing needs for inventories, accounts receivables and mergers or acquisitions, as well as lower demand for cash and liquidity, according to the poll.

Among the banks, tighter lending standards were attributed to a less favorable or more uncertain economic outlook, reduced risk tolerance and less aggressive competition from bank and non-bank lenders. Other reasons included worries around legislative changes, supervisory actions, or changes in accounting standards, as well as lower liquidity in the secondary market for C&I loans.

“The chain of a reaction is usually quite pronounced,” said Gregory Daco, chief economist at EY-Parthenon, in an interview. “Credit is essentially the oil that greases the engine” that allows for the smooth functioning of the economy, he added.

So far, investors are largely positioned for a mild slowdown—one that doesn’t price in a steep contraction in growth over the coming year. That’s partly because the U.S. economy has proved more resilient than expected since the Fed began raising rates. Gross domestic product accelerated to a 4.9% annualized rate in the third quarter—more than double the second-quarter pace. 

Still, some say that it’s only a matter of time before the combination of higher rates and less corporate borrowing takes hold. 

“Economic conditions—they are going to deteriorate and we’ve already started to see that,” Karissa McDonough, fixed income strategist for Nottingham Trust—a division of Community Bank—said on Bloomberg TV Friday. “You are starting to see distressed debt on the rise. You are starting to see problematic access to capital markets for a lot of borrowers. So, we think the economy part is what’s really going to be driving yields down longer-term.” 

This article was provided by Bloomberg News.