The Coming Collision Of Debt & Rates

Authored by Lance Roberts via,

On Tuesday, I discussed the issue of what has historically happened to the financial markets when both the dollar and rates are rising simultaneously. To wit:

“With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.”

I wanted to reiterate this point after reading a recent comment from Jamie Dimon, CEO of JP Morgan, whom, as I have previously written about, makes rather “disconnected” statements from time to time.

“We’re probably in the sixth inning (of this economic cycle), and it’s very possible you’re going to see stronger growth in the U.S. I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”

First, while he talks about banks being much better capitalized, the interesting question is:

“If banks are so well capitalized, why hasn’t FASB Rule 157 been reinstated?”

As I noted previously, FASB Rule 157 was repealed during the financial crisis to allow banks to mark bad assets to “face value” making balance sheets stronger than they appear. This served the purpose of reducing panic in the system, supported “Too Big To Fail” banks, and kept many banks in operation. But if banks are once again so well capitalized, leverage reduced and the economy firing on all cylinders – why is that repeal still in place today? And, if the financial system and economic environment are so strong, then why are Central Banks globally still utilizing “emergency measures” to support their economies?

Likely it is because economic growth remains tepid and banks are once again heavily leveraged as noted by Zero Hedge:

“It is by now well known that consolidated leverage in the system is at an all-time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all-time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.”

However, let me address the leverage issue from an economic standpoint. Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.

This leverage issue is more clearly revealed when we look at non-financial corporate debt and assets as a percentage of the gross-value added (GVA). Again, as above, rising rates have historically sparked a rapid reversion in this ratio which has generally coincided with the onset of a recession.

With leverage, both corporate and household, at historical peaks, the only question is how long can consumers continue to absorb higher rates?

While Mr. Dimon believes we are only in the “sixth-inning” of the current economic cycle, considering all of the economically sensitive areas which are negatively impacted by higher rates, one has to question the sustainability of the current economic cycle?

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) One of the main arguments of stock bulls over the last 5-years has been the “stocks are cheap based on low interest rates.”

5) The massive derivatives and credit markets will be negatively impacted. (Deutsche Bank, Italy, etc.)

6) As rates increase so does the variable rate interest payments on credit cards and home equity lines of credit. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a contraction in disposable income and rising defaults.

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend payments have been done through the use of cheap debt, which has led to increased corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on lower borrowing costs. Higher borrowing costs leads to lower CapEx.

10) The deficit/GDP ratio will rise as borrowing costs rise. 

You get the idea. Interest rates, economic growth, and credit are extremely linked. When it comes to the stock market, the claim that higher rates won’t impact stock prices falls into the category of “timing is everything.”  

If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes. With rates now at extensions only seen in 7-periods previously, there is little room left for further acceleration in rates before such an outcome spawns.

As Bridgewater just recently noted:

“Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.”

Here are the things that you need to know:

1) There have been ZERO times when the Federal Reserve has embarked upon a rate hiking campaign that did not eventually lead to negative economic and financial market consequences.

2) The median number of months following the initial rate hike has been 17-months. However, given the confluence of central bank interventions, that time frame could extend to the 35-month median or late-2018 or early-2019.

3) The average and median increases in the 10-year rate before negative consequences have occurred has historically been 43%. We are currently at double that level.

4) Importantly, there have been only two times in recent history that the Federal Reserve has increased interest rates from such a low level of annualized economic growth. Both periods ended in recessions.

5) The ENTIRETY of the“bullish” analysis is based on a sustained 34-year period of falling interest rates, inflation and annualized rates of economic growth. With all of these variables near historic lows, we can only really guess at how asset prices, and economic growth, will fair going forward.

6) Rising rates, and valuations, are indeed bullish for stocks when they START rising. Investing at the end of rising cycle has negative outcomes.

What is clear from the analysis is that bad things have tended to follow sustained increases in interest rates. As the Fed continues to press forward hiking rates into the current economic cycle, the risk of a credit related event continues to rise.

For all the reasons currently prognosticated that rising rates won’t affect the “bull market,” such is the equivalent of suggesting “this time is different.”

It isn’t.

Importantly, “This Cycle Will End,”  and investors who have failed to learn the lessons of history will once again pay the price for hubris.


IDrankWhat Thu, 06/07/2018 - 17:58 Permalink

You may not agree with the author's entire belief system but he did have his [area of] expertise...

"There is one bit of advice given to us by the ancient heathen Greeks, and by the Jews in the Old Testament, and by the great Christian teachers of the Middle Ages, which the modern economic system has completely disobeyed. All these people told us not to lend money at interest: and lending money at interest — what we call investment — is the basis of our whole system. Now it may not absolutely follow that we are wrong. Some people say that when Moses and Aristotle and the Christians agreed in forbidding interest (or “usury” as they called it), they could not foresee the joint stock company, and were only dunking of the private moneylender, and that, therefore, we need not bother about what they said.

That is a question I cannot decide on. I am not an economist and I simply do not know whether the investment system is responsible for the state we are in or not. This is where we want the Christian economist. But I should not have been honest if I had not told you that three great civilizations had agreed (or so it seems at first sight) in condemning the very thing on which we have based our whole life."

C. S. Lewis – Mere Christianity

[Edit: adapted from a series of BBC radio talks made between 1941 and 1944 and originally published in 1952]

Consuelo IDrankWhat Thu, 06/07/2018 - 18:28 Permalink

Whilst savings & prudence may go out of style, they never leave, and will return in full glory at some point - probably in the near future.   And like the few left alive which have memory of the 30's, so too will the indelible stain of debt and profligacy be seared into the minds of the young ones today who are about to witness a cleansing event first hand. 

In reply to by IDrankWhat

itstippy Thu, 06/07/2018 - 18:01 Permalink

"If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes."

Lance is writing to his audience of investors, who read his newsletters hoping to gain insight in their efforts to make money by financial skullduggery.  I'm not one of those, and while I like reading his articles I don't agree with his term "negative outcomes". 

I'd like to see heavily indebted individuals, corporations, and government entities squeezed by the balls until their eyes pop out of their sockets.  Their wild-assed, fearless accumulation of debt has caused no end of economic distortions to my disadvantage, me being prudent and unwilling to borrow money to pay for things.  Raise interest rates, tighten the money supply, make the debtors and speculators scream for mercy, and I'll be happy with that outcome.

Don Sunset Thu, 06/07/2018 - 18:44 Permalink

I predict the shit starts hitting the fan (start of loss of government services at all levels) by end of Q2FY19.  The USG will be hemorrhaging with deficit spending totally unleashed and out of control like never before.  May have to cut taxes a whole lot more.  Bhahahahahaha!

Archibald Buttle 3-fingered_chemist Fri, 06/08/2018 - 02:28 Permalink

i'm thinking the big sign to look for is when things start not getting rebuilt after disasters.  when you start seeing people evacuated katrina-style, and nobody doing any rebuilding afterward, that will be when the sheeple yawn and rub their bleary eyes.  after a cup of coffee or two they will (maybe) start to give a shit and then get angry about what the government has really been up to while they were asleep. 

In reply to by 3-fingered_chemist

ElTerco Fri, 06/08/2018 - 00:44 Permalink

"2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments."

Correction -- stupid people buy payments, not houses. Smart people buy houses and not payments.