Many economists currently believe the US economy will slow dramatically following the first interest rate hike, thus limiting the number of rate rises the central bank can deliver, or potentially forcing a policy reversal in fairly short order. The argument appears to rest on the idea that the economy is much more heavily indebted than it has been historically, and therefore it will not be able to stomach the higher interest costs that will seemingly inevitably follow. We disagree and think that on closer inspection it is far less about the level of debt outstanding and much more about the composition of that debt (see chart 1), what the debt has been used for, its maturity and interest sensitivity. On all of these metrics the threat to growth looks limited.
The really positive development in this recovery is the extent of deleveraging (reduction in borrowing) that has taken place on consumer balance sheets. Consumers have paid down significant quantities of short-term borrowing for consumption purposes while at the same time have taken on limited additional debt in the form of new mortgage borrowing. Not only is the level of outstanding consumer debt significantly lower, but the sensitivity of this debt to interest rates is likely to be lower compared to history. With ongoing refinancing of mortgage debt into ever lower fixed 30-year mortgage rates, the bulk of US mortgage borrowing is now protected from higher interest rates.
The result is a debt service burden at historical lows as a percentage of personal disposable income (see chart below). With incomes now rising as wages pick up, modestly higher interest rates are unlikely to have much of an impact on the consumer debt service burden, and will thus be unlikely to weigh heavily on consumer spending decisions going forward.
Non-financial corporate debt – higher levels but reduced sensitivity
Corporates have been responsible for significant debt issuance over recent years and have contributed heavily to the rapidly rising level of debt stock in the economy. According to the Barclays US Aggregate Index, the volume of outstanding marketable corporate debt in the US has doubled since the financial crisis. Following the financial crisis, investor appetite has been particularly strong for assets that provide both capital security and income. When coupled with aggressive quantitative easing policies from the central bank, which reduced the yield available in conventional government bonds, investors have migrated into higher yielding alternatives, such as corporate bonds. Corporates have been quick to take advantage of this demand, issuing debt in record quantities, locking in particularly cheap long-term rates of borrowing.
In the current cycle, some of the money raised has been used for shareholder friendly activity (such as share buybacks) rather than an overinvestment in the growth cycle. This process of financial engineering has changed the shape of the corporate balance sheet in a material way. Given the relatively lower levels of capex activity, going forward it is less likely we will see the scaling back of investments that historically follows on from higher rates.
In our opinion, this means that companies’ sensitivity to rate hikes is diminished and indeed there may even be a pent-up capex cycle waiting to play out.
Financial sector debt – deleveraging and unlikely to re-lever
The financial sector has also seen a significant reduction in its debt outstanding. However, this is more as a result of structural changes following the financial crisis. Borrowing has contracted as a result of bank regulation and the need to shrink the balance sheet. Because of this we do not think the financial sector is likely to relever anytime soon.
Historically, banks have been particularly sensitive to rising rates, although this is largely due to the sensitivity of the assets they own. This sensitivity has fallen with the reduction in outstanding debt and a move back towards a more normal interest rate environment may actually be positive. In fact, some financial institutions have publicly disclosed that they expect a Fed rate hike to be beneficial as interest income increases.
Public sector debt - the fiscal headache
A significant majority of the increase in the debt load of the US economy in the post crisis period has accumulated on the public sector balance sheet. This resulted from the government being forced to run large fiscal deficits in order to help stabilise the economy, which was facing deep recession. Furthermore, the US is in desperate need of far reaching fiscal reform and will eventually have to deal with what will certainly be a continuation of the recent rapid growth in the debt stock, given health care and social security burdens. However, with political gridlock in Washington this is looking like a distant prospect.
The developments on the public sector balance sheet, while problematic for the US Treasury in trying to fund the ongoing shortfall in revenue, are unlikely to change the potential sensitivity of the economy to higher policy rates.
Higher rates are not necessarily bad news for growth
The text books could be wrong; higher interest rates might be stimulatory.
This is certainly a somewhat controversial idea and clearly runs counter to conventional thinking about how interest rates impact the behaviour and incentives of consumers and corporations. However, following such a long period of unconventional monetary policy, in the form of balance sheet expansion and zero interest rates, we are paid to think in unconventional terms about the incentive structures these policies create, as well as the behavioural responses they elicit.
Since the financial crisis investors have been heavily incentivised to buy interest generating assets, largely as a function of income preference and the desire for capital security, as well as significantly positive returns. Thus corporates have been incentivised to provide income to investors as opposed to reinvesting in their businesses. It is no surprise then that the corporate capital expenditure cycle has consistently been lower than expected in recent years.
The catalyst for corporates to shift their focus back to growing their business, rather than returning cash to shareholders, could well be higher interest rates, as confidence returns that growth is strong enough to support higher rates and animal spirits are revived within the corporate world. Furthermore, higher rates themselves could undermine the value embedded in income-paying assets as the discount rate is raised, helping to shift investor attitudes towards growth.
Expect surprises: a reassessment needed of ‘slow and gradual’
Our basic premise is that following an extended period of zero rates and quantitative easing, incentive structures for financial market participants have been deeply distorted, compared to what traditional models would indicate. This could well mean that when rates do start to go up, the traditional working assumption that the economy will slow rapidly may be very misplaced indeed.
Further, if the worries about slowing growth do not play out, then we believe the decision will be taken to follow up quickly with a second hike, and the forecast for the likely path of subsequent increases could also become more aggressive. Certainly there is some precedent for this (see chart 3) with the path of the last four hiking cycles all faster than the Fed’s current projections.
