America's Luck Running Out As Rising Rates Start To Bite

Authored by Simon White, Bloomberg macro strategist,

The highest interest rates in almost two decades have so far failed to plunge the US into recession.

But that will change through 2024 as rising borrowing costs bite, making a slump later next year increasingly unavoidable.

“Human impatience crystallized into a market rate,” said Irving Fisher about interest. That impatience grew extreme in the wake of the pandemic, fomenting a rapid rise in inflation and prompting the Federal Reserve to raise rates in its fastest ever rate-hiking cycle.

The elegies were swiftly written for the booming economy as many (myself included) assumed it would not be long before a full, NBER-defined recession would ensue. But so far it hasn’t turned out like that.

Most assets, notably equities, credit and gold, continue to be unpriced for a downturn.

Yields and the curve, on the other hand, are more immediately vulnerable to a re-pricing (higher yields, steeper curve) as a recession is less likely in the shorter term. However, as the economy becomes more recessionary next year, stocks and credit will face mounting downside risk.

How has the economy been so unexpectedly resilient, allowing assets such a relatively easy ride? The finger points squarely at its reduced sensitivity to higher rates. Households, corporates and banks have all either benefited from higher rates, or have been shielded from the brunt of their effects.

But that won’t last, and even if rates are moderately lowered, the pass-through effects will cumulatively mount, significantly increasing the chance of a recession later next year.

Let’s start with a scary chart you may see more of in the coming weeks, showing a rapid rise in personal interest payments:

Households are net-interest rate payers, and this sort of chart suggests the sector is on the precipice. But context is needed. Most importantly, personal interest payments do not include households’ largest running cost: mortgage repayments.

The “sticker price” for mortgages has risen considerably as the Fed’s rate climbed and mortgage spreads blew out (for reasons discussed here). But the sharp decline of those on ARMs (adjustable rate mortgages) means many borrowers have ~25-year fixed-rate loans struck when interest rates were still very low.

As the chart below shows, the surfeit of lower-rate loans means that the effective rate remains considerably lower than the rate for new mortgages, and is rising only slowly.

A more complete picture of household finances is revealed when we include receipts. Adding in interest income, dividends and, most significantly – since we can’t ignore the $2 trillion fiscal elephant in the room – transfer payments, we see households’ net non-wage related income is still above its pre-pandemic average (and that’s with wages still growing positively in real terms).

The blunting of the pass-through from higher rates to mortgages has been the game changer for households this cycle. The debt-service ratio (the ratio of total debt repayments to disposable income) is only back to its pre-pandemic average, despite the consumption DSR hitting highs not seen since just before the GFC.

The DSR, although it is lagging, is a more complete indicator of household-finance pressures. For instance, credit-card rates might look usurious at over 20%, but lots of people pay off their card before interest accrues (e.g. 44% didn’t carry a balance in 3Q22, according to Lending Tree). Undoubtedly there are many households feeling a strain from rising rates, but the data shows that in the aggregate the sector is in much better shape than some pessimistic-looking charts would suggest.

Unlike households, banks tend to be outright beneficiaries from rising interest rates (unless of course you’re run like SVB). Large US banks (those in the KBW Bank Index) have seen their net interest margins (NIMs) widen as rates rose. NIMs have climbed as banks’ net interest income has risen, while they have also been reducing their duration exposure by selling down USTs and MBS.

The corporate sector is another beneficiary of rising rates. It played the rate cycle deftly, terming out debt when rates were low through 2019-2021, then reducing average duration as rates rose (by necessity for some).

On top of that, corporates increased their holdings of bills, money market funds and savings deposits to take advantage of rising short-term rates. Interest receipts rose more than costs such that net interest income of corporates has been rising, while interest-rate coverage ratios of many companies is high. It’s been as if interest rates had been cut for corporates.

But all good things must come to an end, and higher rates will increasingly bite. The chart below shows that the net interest expense of corporates is set to rise, potentially sharply, next year.

Furthermore, from next year the amount of corporate debt maturing - which will have to be rolled at a much higher rate - will ratchet up.

Households will face increasing headwinds too. While the proportion of ARMs now is much lower than the ~45% it reached prior to the GFC, it has risen off its lows and currently sits at just below 25% (in value terms). That means the effective mortgage rate of households will keep rising. Also, interest income will roll over as short-term rates peak, while net transfer payments are likely to drop as the impulse from fiscal spending moves past its peak.

At the same time, the interest-rate bill of the government will continue to balloon. Based on the rise in 10-year yields, government interest-rate payments could rocket to over 4% of debt outstanding next year, in the region of $1.4 trillion.

Not only will this keep the fiscal deficit elevated, the simplistic notion that interest repayments will filter back through the economy is erroneous, given only around a tenth of USTs are held by the corporate and household sectors. The rest are owned by financials or foreigners who are more likely to reinvest interest income, or spend it outside of the US.

The government’s need to borrow to pay a sharply rising interest bill will exacerbate liquidity headwinds which are already primed to mount next year as the Fed’s reverse repo (RRP) facility depletes.

Indeed it is the Fed that explains the exceptional rate-resilience of the economy, with the central bank warehousing over $7 trillion of duration risk on its balance sheet. But that will progressively diminish as quantitative easing marches on.

Interest rates’ punch has been pulled so far, but the clock is running down for when their full impact will be felt. The economy’s luck is running out.