Founders Perspctive

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The earth’s climate has changed many times over its history from bitter ice ages to much warmer periods. One statistical relationship holds true through all these periods, the higher the temperature, the less ice in the arctics and the higher the ocean level. So one variable, temperature, changes the configuration of all land masses.

The level of interest rates plays a similar role throughout the economy and the markets. Higher or lower interest rates change the entire financial landscape.

Almost all lending rates are tied to the Fed Funds Rate, the rate for overnight lending by the Federal Reserve (Fed). One example of direct ties are margin loans for our clients at Schwab which are often quoted at 2.0% plus the Fed Funds Rate. An example of indirect ties are 30-year fixed mortgage rates which have no direct ties to the Fed Funds Rate, but have sharply risen for borrowers.

Carrying Costs. Higher interest rates raise the carrying cost of anything bought with credit… homes, automobiles, commercial buildings, capital equipment, inventories and so forth. See Chart 1.

As rates go up, fewer things are either affordable or make economic sense thus dampening economic growth. For example, a new business expansion that made good sense when the prime rate was 3.0% no longer works with its current 8.0% rate.

Less growth means less demand for goods and services which reduces inflation. This was the stated goal of the Fed as it raised the Fed Funds Rate over the past 12 months from effectively zero to now 4.75%-5.0%. It is working as inflation has steadily declined.

Housing is a good example. Home sales plummeted in 2022. As a result, the average home price came down (over 12 months) for the first time since the financial crisis. The ripple effects of less new housing are extensive – appliances, landscaping, furniture, and much more, all rise or fall with the housing industry.

Rollover Costs. After a decade of extremely low interest rates, most individuals and companies had financed their debts at very low interest cost, whether that be mortgages, bond issues, or virtually any other type of loan.

After the steep rise in interest rates over the past year, any debt that comes due, and needs to be rolled over, will jump to a much higher rate. This will reduce the cash available for other purchases, salaries, or capital investment.

Commercial Real Estate (CRE) will have its highest dollar amount of rollovers in a generation this year. Already, major property owners such as PIMCO and Brookfield have walked away from properties they owned. Obviously, there will be more foreclosures and bankruptcies ahead. Banks will also be much more hesitant to rollover CRE loans. See Chart 2.

Hurdle Rates. Higher interest rates directly impact the risk/reward equation within investment choices. The higher the rate on “risk free” money market accounts, the more serious the competition (hurdle rate) they offer to other investments. Less risk taking by investors means less investment in economic activity.

Portfolio Declines. As the yields on newly issued bonds rise, the market value of previously issued bonds fall. It does not matter whether the bonds are super “safe” U.S. Treasury bonds, corporate bonds, mortgages, or municipals. This is what caused 2022 to be an especially bad year for virtually all bond investors.

Summary. The higher costs of carry and rollovers, as well as foreclosures, mostly occur when loans mature or new projects are deferred. This is why raising interest rates has a lagged impact of 6-12 months on economic activity. Even if the Fed is close to – or even at – the end of its rate rising, the impact of today’s rates will continue to slow the economy throughout 2023.

Fortunately, most of the economic impact is from the interest rate itself, not from the credit quality of the borrowers or the underlying investments. This means that as interest rates come down, much of the constrained economic activity can resume. The question then becomes, when does the Fed believe its inflation objective is achieved enough that it can begin that process.

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