Wall Street’s Fix
Once again, yesterday demonstrated Wall Street’s abiding need for cheap credit. The Federal Reserve announced its latest price for credit, called the Fed Funds interest rate, in a ceremony as closely watched as the Oscars. So essential and precise is the cost of credit that it is quoted in tenths of a percent, or basis points. An amount so small that we use this number for nothing else. Basis points are used only in the financial world.
One basis point interest on a hundred dollars is a dime, that’s right, ten cents. And that’s not for a week or a month. That’s ten cents interest for a year.
Yesterday Wall Street was anguishing over whether the Federal Reserve would raise its base interest rate by 75 basis points or 100. A difference of 25 basis points, or 25 cents on your $100 savings, per year. Such a slight difference that it’s a wonder that anyone paid attention.
But yesterday, it was as if the Super Bowl and World Series came all wrapped up together. Thousands, perhaps millions of traders sat transfixed at their terminals, ready to hit the buy or sell button based on the outcome of the Fed’s interest rate decision. Yes hundreds of billions of dollars would move based on the announcement of a new Interest Rate. It’s a wonder to behold.
And that’s just how dependent Wall Street and our financial system, in general, are on credit. In general terms, the higher the interest rate, the less investment. Had the Fed raised rates above expectations, say more than 100 basis points, they would have crashed the markets. Those traders would have all hit their collective sell buttons.
Why they would all hit the sell button is a little complex. But briefly, the answer goes like this. In the initial phase, the higher interest rate and higher cost of credit would mean that many of the largest investors, read hedge funds, some Exchange Traded funds, some Mutual Funds, and some Private Equity funds, borrow the money to invest.
It’s common, for instance, to see a hedge fund borrow half again its investment to buy or sell stock. Some specialty funds, like mortgage REITS and others, can borrow 90% of their investor’s equity. Leverage means these funds are always on the razor’s edge.
They must manage between the potential gain of holding a long position and their cost of carrying. The interest they must pay to maintain that investment. As interest rates rise, their cost of carry increases, and sooner or later, they will need to sell their assets.
Why do you think the big 5 Tech companies, Amazon, Apple, Alphabet, Microsoft, and Meta, have all performed so well over the years? They’re the most popular investments for large, leveraged investment companies. What makes matters worse is that many of these leveraged investors hold identical positions. Today much of the support for the markets rests on borrowed funds as large investors utilize financial leverage to enhance returns.
It’s also why a considerable decline in one stock like Meta (are you listening?) can lead to a stampede. Initial sell orders amplified as other investors must also sell their investments to meet the margin calls. Selling begets selling, in this instance.
And while we last saw this kind of market behavior a while ago, you can still bet that margin sales will be a large part of any future market decline.
But declining financial markets are only the first phase of drastically raising the cost of credit and interest rates. Corporate America is not immune to higher rates. Many of the top 500 companies in America are chock-full of debt. From commercial paper to short-term revolving credit to long-term corporate bonds, these companies are as highly leveraged as ever.
The retail sector is a particularly vivid example of just how far corporate leverage has gone. The average retail company borrows to purchase inventory, lease their storefronts, and may borrow for any expansion.
Retailers are among the most highly leveraged companies around. With higher interest rates come higher financing costs. With its corresponding sales decline, a recession would decimate the retailer’s income. It would mean higher finance costs and lower sales income. It’s a recipe for bankruptcy.
Against this background, the Federal Reserve steps forward eight times a year to announce its latest cost of credit. An obscure reading called the Fed Funds Interest Rate quoted in infinitesimal basis points.
For many of us, it is an event that’s often ignored.
The Fed’s Interest Rate Announcement will determine the immediate course of our economy in the weeks ahead. For Wall Street, it’s a rare moment when we will take a new financial direction. It can even mean the difference between future success or failure.
Econ Briefs
“It’s premature to think about pausing interest rate hikes.”
With those words, the Chairman of the Federal Reserve, Jerome Powell, told the financial markets that he’s not finished with tightening monetary conditions. Strong comments from the soft-spoken Powell. And a sure indication that the Fed’s fight against inflation is far from over.
Not since Paul Volcker have we seen a Federal Reserve take such an aggressive stance in tightening financial conditions. You’ll recall that Volcker dramatically raised interest rates in the early 1980s, the last time we had runaway inflation as we have today.
Most economic historians credit Volcker as providing the primary impetus that stopped inflation. Undoubtedly, Jerome Powell is reading that history and following in Volcker’s footsteps.
Here’s the issue. Volcker faced demand-driven inflation with annual GDP growth the quarter before he began tightening, increasing at a double-digit rate.
Powell faces an economy that is stimulus-driven. Although GDP growth has been nearly as high as back in the 80s, it is purely stimulus-driven. From my perspective, inflation is already declining as the stimulus fades into history.
So it’s actual demand-driven inflation of the 80s versus stimulus-driven inflation today. Not at all the same economic conditions.
In other economic news.
Not to be outdone by the “Yanks,” the Bank of England announced that they would raise their base interest rate by 75 basis points. The difference is that this leaves the English rate at 3%, one total percentage behind the US.
A slate of economic reports is now coming over to my desk. The first initial claims for unemployment are coming in line with estimates at 217k new claims.
The Balance of Trade comes in slightly hotter than expected. TheUS Trade deficit for October was $73b.
Big news coming from earnings. Two vaccine-related companies have reported disappointing earnings. Principal Vax maker Moderna and Vax distributor Zoetus are down about 10% on their results.
Big news.
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