The procyclical forces behind the Fed’s rate hike train

By Edward Harrison On Apr 26, 2018

This is today’s links post. And I want to highlight a theme that runs through several links today. That’s pro-cyclicality. One reason I am not bearish on the US economy yet is because I think a lot of pro-cyclical activity accompanies the initial surge in interest rates. In this particular cycle, we are now seeing both fiscal and regulatory policy acting pro-cyclically as well with Trump as President.

Later in the cycle, as rates march higher, earnings will materially erode, financial distress will hit Ponzi borrowers, and default rates will start to rise. That’s when we will see layoffs and the potential for recession.

Interest income works pro-cyclically

You’ve probably heard me say this before, but the private sector is a net receiver of interest. That means, all else equal, rising rates increase net interest receipts and raise income in the private sector. So, to the degree the Fed is raising rates, the interest income channel acts pro-cyclically.

In this cycle, with rates near zero, we didn’t have to worry about this because banks were not passing through interest rate hikes to savers. But as rates rise from here, interest income will be a factor driving increased incomes.

Last week I heard a credit union executive on financial media touting this. He said community banks don’t have shareholders. Their customers are there shareholders. Traditional banks pay shareholders via dividends, distributing as much as is prudent given anticipated future capital requirements. The credit union executive said his goal is to distribute as much of their income to members via savings accounts as possible. And he touted the rising deposit rates as an example of how the credit union accomplishes this.

Debtors will act pro-cyclically too

For the Fed, that’s not the only problem with using rate policy to slow things down. Debtors see the rate hike train coming and decide to pull the trigger now and lock in a rate. For example, look at how this Bloomberg article describes the recent bond offering of WeWork. (Note, by the way, that WeWork does some pretty funky stuff with its EBITDA calculations.)

The company is dangling preliminary yields of 7.75 percent to 8 percent to sell $500 million of bonds to investors in its inaugural deal, according to a person familiar with the matter who asked not to be named because the deal is private. Notes with comparable ratings and maturities typically yield about 5 percent, according to data compiled by Bloomberg.

The co-working space company backed by SoftBank Group Corp. joins a wave of high-flying, but cash-burning, tech firms tapping debt markets just as interest rates start to creep higher. Uber Technologies Inc. in March sought a loan even while burning through cash and posting an annual loss. Netflix Inc. borrowed $1.9 billion on Monday after allaying cash-flow concerns with continued subscriber growth.

The managers of these speculative enterprises don’t want to wait until rates go higher. And so, we should expect a slew of bond offerings and initial public offerings for equity. And capital investment should be pulled forward as a result. That will boost growth, at least temporarily.

Fiscal is already pro-cyclical

One feature of this cycle that is unique is fiscal policy. Normally, you expect to see the governments coffers filling up with dollars as tax revenue surges late in an economic cycle. But the recent Trump Tax Cuts are boosting deficit spending just as this cycle is peaking. That will put a floor under demand and help prevent a recession.

Expansionary fiscal policy will also invite an offsetting tightening in monetary policy, especially to the degree signs of inflation increase. And I expect this tightening to further work pro-cyclically through interest income and credit demand channels, pushing up the Fed’s rate hike timetable.

Regulations are the final procyclical puzzle piece

The Trump Administration sees regulations as an impediment to growth. And it has been aggressive in cutting those regulations as a result. Greg Ip has an interesting take on this at the Wall Street Journal. Greg says:

Deep into an economic boom with asset prices near records is when you’d expect the U.S. financial system’s guardians to tamp down risk-taking. Instead, federal regulators and legislators are doing the opposite—watering down, narrowing or declining to enforce rules passed after the financial crisis.

The changes are modest and don’t foreshadow a crisis any time soon. But the timing is definitely awkward. They will stimulate lending and risk-taking at a time when the industry is lowering its own standards amid a near-record economic expansion.

Much as this year’s tax cut may overheat an economy already near full employment, the deregulatory push could aggravate excesses that come back to haunt the economy in its next downturn.

That’s something to think about for sure.

Expect more growth

My view: interest rates are rising because the economy can support it. Incomes are rising. And as I was writing this piece, jobless claims hit a 49-year low of 209,000. Even with a soft GDP growth number tomorrow, the US economy will continue to chug along. In short, expect more growth.

Corporate leverage is a problem, though. I told you that Frank Veneroso did a bottoms-up balance sheet analysis and concluded that the National Income and Product Accounts wildly understate the increase in corporate leverage in the US. At some point, this leverage will erode the ability to boost earnings through buybacks. And weak nominal growth will result in declining earnings.

Meanwhile, as rates march higher, distress will build for speculative and Ponzi borrowers. And at some point, defaults will begin to increase. That’s when we will have to worry. We are not there yet. There’s still a long way to go before we get there too.

The thing to remember though is that, to the degree rate increases are initially pro-cyclical, you will need a lot more of them to work anti-cyclically. And therein lies the danger, as the pace of increases could then prove too much.

Links

Pro-cyclicality