In the latest testimony by Jay Powell, chair of the Federal Reserve to Congress, he praised the current condition of the U.S. economy. “Robust job gains, rising after-tax incomes and optimism among households have lifted consumer spending in recent months.” Clearly, the fiscal policy has advanced economic growth with the recent tax cuts. Optimism in the business community has taken hold with a growth-friendly leadership and lowering regulations.
The Fed has hiked short-term rates by 1.50% since the end of 2016 and has indicated we may see several more 25 basis point hikes this year and next. Increasing rates make borrowing cost higher and will tend to slow down growth.
The classic balance with monetary policy, the actions taken by the Fed, is to maintain price stability with a small level of inflation on one side and full employment on the other side. This lesson was taught to me early in my first macroeconomics class. So, the Fed is to act as some monetary thermostat, heating up the economy when activity is too cool and cooling it down when it is too hot. Ideally, changing the thermostat is to make the economy move along at a very comfortable level, not growing too fast and never falling into a recession.
But, just as an old thermostat may not work to keep your house comfortable, the Fed’s actions are never perfect. Furthermore, there are other motivations of the Fed. Remember the Fed is the bank of banks. Powell, as with most other Fed leaders, spent decades working for investment banks. The Fed was created by our nation’s top bankers over a century ago and there is motivation to keep the financial industry happy even if these actions may cause some pain to the rest of the economy.
At times, banks love when rates rise. This comes when repricing earning assets widens the margin more than the need to reprice bank deposits. Forbes discussed this in mid-July when analyzing the second quarter earnings reports from our nation’s big banks. “What really stands out is how well JP Morgan and Citigroup performed in Q2 despite 10-year yields remaining so low. It’s arguable that few analysts (and probably few of the economists at banks themselves) would have thought 10-year yields would be in the 2.85% range this far into the year, but here we are in mid-July, and that’s basically where the yield sits. Thought shares of the financials have been punished as rates remain stubbornly low, it’s possible bank stocks could get rewarded if yields start to find more traction and revisit the 3% level. That’s where yields were briefly in May, and with the Fed still in a hiking cycle, it’s not necessarily too aggressive to think yields could potentially make it back to that level sometime in the coming months.”
So as rates shoot up, bank profits follow. The real risk comes if the Fed increases short term rates to a level where they are higher than longer term interest rates. Almost every time in the past century when this has happened, a recession has followed. The chart below, from the St. Louis Fed, shows the differential between the 10-year and 2-year U.S. Treasury rates. The gray columns are recessions, or downturns in economic growth for two quarters or more.
Note that each time the yield curve has inverted, or short-term rates have risen higher than long-term ones, a recession has followed. We are currently getting close to a level of the yield curve flattening and turning negative.
There is another factor in play. Rates have dropped to levels so low after the Great Recession, that rates need to be at a higher level if the Fed needs to act to stimulate the economy again. There is more simulative power in a Fed Funds drop from 3% to 1% than from 1.5% to 1%. In other words, the Fed needs rates to be higher in order to give it ammo to fight the next recession more effectively. If rates continue in super low historic territory, the impact of lowering rates to grow the economy is muted.
The Fed could take rates negative, a move that European central bankers have done, but that tends to not have good results for the banks or the economy.
One takeaway from the chart above is to note how much of the chart is above the horizontal black line. It shows it is normal for someone lending money for a longer term would receive a higher interest rate than someone lending for a shorter term. We refer to this a duration risk, or the risk of losing purchasing power the longer you peer into the unseen future.
But note how the line snaps back quickly into the positive after dipping negative. The risk in institution profits is for a lender or CFO to have a large portion of outstanding loans locked for long term fixed rates on their balance sheet during the times the rate is negative. The curve will normalize and your cost of funds will tend to rise. This has the potential to squeeze net interest margins. It is smarter in times like these, to not commit to low long term fixed rates on loans or to find a way to hedge against the duration risk if you do.