The Impending Interest Rate Storm
Next Wednesday, the Federal Reserve’s Open Market Committee will meet to decide the next move in interest rates. There is no question that when that meeting ends, rates will be higher. The only question is: by how much?
For many on Wall Street, and I dare say for most of the country, this will be the much-needed step to curtail inflation. One Wall Street banker exclaimed that he couldn’t wait for the Fed to raise rates because that would mean the “rescue plan” would start that much sooner.
The underlying assumption here is that by raising interest rates, the Fed will somehow stop inflation. I don’t subscribe to that theorem, but let’s set that part of the argument aside for the moment.
Here’s the part we can all agree on: we have before us higher interest rates. Today let’s consider just what that part of the monetary equation may mean.
2008 was a watershed year in our country’s financial history. Granted to the casual observer, it probably did not seem that way. It was a recession year. Some, but not many, lost their jobs. A couple of financial businesses went bankrupt. Most would consider it just a bump in our country’s economic progress.
Lehman Brothers, one of the most well-established financial firms, filed for bankruptcy, and the stock market lost over $1.2 Trillion. Most on the Street considered this one of the worst financial crises ever. Warren Buffett called it an “economic Pearl Harbor.”
But most significant for today’s discussion, 2008 was when the Federal Reserve lowered the interest rate. The Fed held interest rates at essentially zero and kept them there for years.
Suddenly there was no cost to borrow. The Fed did this to add liquidity to the financial system. And those companies who were in trouble, companies such as Citi Group, the fourth largest bank in the Nation, could recover from any bad loans or investments.
Zero Rates were an off-the-wall strategy that the Fed had never done before. And yet it worked. The country recovered, and the financial sector Wall Street and the Big Banks became financially strong again. The 2008 Recession was behind us, in our rearview mirror.
But one thing didn’t change, Zero Interest Rates. Now to its credit, the Fed did start to raise rates to a more normal level in 2016. But they quashed that in 2020 when the Covid Pandemic struck. Back down to zero, we went again.
You had a choice if you were a Corporate Treasurer or Chief Executive during this time of zero interest rates. Should the firm’s capital come from issuing stock, or should you borrow the money?
Borrowing capital is accessible. Just walk into your friendly banker’s office, fill out some paperwork, and walk out with the cash.
Selling stock is complicated. There are prospectus to be written, due diligence meetings, and convincing brokers to sell the stock.
Most American corporations choose the borrowing route. From that 2008 recession until today, American Corporations nearly doubled their corporate borrowings. From $12 trillion borrowed back then to $24 trillion today.
Today things get interesting.
Remember that Fed interest rate meeting next week? Right now, their base interest rate is at 2.33%. Let’s assume they raise rates by another 3/4%, as most of Wall Street believes they will. At 3% interest, the annual interest payment for American corporations just increased by $700 billion!
That’s an additional $700 Billion that will need to come from income, income that might otherwise flow to shareholders in the form of dividends, or income that might purchase new plants and equipment.
So, as you can see, there is a mighty big step between the Fed raising interest rates and lower inflation. And that step involves dramatically reducing corporate incomes as debt interest payments climb.
Telling. It is a process that has already begun. From Q1 to Q2 of this year, Corporate net worth declined by $400 billion, while corporate debt (with somewhat higher interest) expanded by $300 billion.
PS Let me give you some idea of the magnitude of this move to higher borrowing (higher corporate leverage).
In 2007 Corporate Net worth in America was $5.4T. In June of this year, Corporate Net Worth was $5.3T. Yet corporate borrowing from Q4 2007 to Q2 2022 has doubled.
Economic News
Today would have been the first day of a nationwide Rail Road Strike, a strike that would be a devastating blow to this very tenuous economy. These negotiations are particularly complicated, involving several different unions. Fortunately, both sides have agreed to continue talks during an extended “cooling off” period.
As a consequence, there is some confusion in the reporting. While it is true that some unions have agreed with the Rail Roads, CNBC reports that the two largest unions, representing about half the railroad employees, have not resolved their differences with management. The deadline for these extended negotiations is tomorrow at midnight. So don’t pop the Champaign corks just yet. This one isn’t over.
Lots of trade news this morning, as Japan and the European Union are reporting record trade deficits for last month. Trade Deficits are an indication of the global imbalance in economic resources. After all, it is primarily energy-causing deficits for both Japan and the EU.
Of course, neither of these trade deficits come even close to the current trade deficit record holder, the United States, whose deficits are about three times higher than Europe’s.
The major report this morning has been Retail Sales. And it’s another of that good news, bad news. Overall Retail Sales for August were up 3/10th %, beating Wall Street estimates. However, it turns out that those sales were primarily in Autos. Take away the cars, and retail sales declined by 3/10th%.
It’s a light day in earnings, with just a few prominent companies reporting. First will be media company Bolero, followed by Adobe Systems. Adobe is already in the news, announcing their $20 billion purchase of design platform: Figma Systems.
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