Wrecking Ball

Wrecking Ball

Published On: October 7, 2022

Written by: Ben Atwater and Matt Malick

After markets continued their breakdown in September, you may be asking yourself, why is the Federal Reserve wrecking the market and the economy? And how are they doing it?

The Fed is intent on stalling the economy to bring down inflation. The U.S. Consumer Price Index (CPI) rose 8.26% year-on-year as of August 2022. This compares to a rate of 5.25% a year ago and a 1.31% reading two years ago. Inflation has become a problem, particularly as compared to the Federal Reserve’s long-term inflation target of 2%.

Therefore, the “why” is plain and simple. The Fed needs to knockout inflation. And their most blunt instrument to do so is to raise interest rates. Namely the Fed Funds rate, which the Fed solely controls and is the interest rate that depository institutions use to lend their reserve balances to each other. The Fed is intent on raising rates until they break inflation.

However, the devil is in the details. Fed Funds rate changes can take as long as 18 months to filter through the economy. The reason it takes time for Fed policy to work is because their policy changes need to influence human behavior.

Over the last nine months, the Fed has raised the Federal Funds rate from 0.25% to 3.25%, a thirteen-fold increase. Yet core inflation (ex-food and energy) continues to stubbornly increase. In our view, the Fed believes it cannot beat back inflation without reducing asset prices, whether that be the value of housing, bonds, stocks or other businesses.

In the housing market, the math of higher interest rates is straightforward when it comes to mortgages. With 30-year mortgage rates increasing to a current level of 6.7% from 2.99% a year ago and 2.87% two years ago, the housing market is predictably stalling.

What difference does this increase make for a home buyer financing $600k? At 2.87% a 30-year principal plus interest payment is $2,449.53. At 6.7%, the same financing will cost $3,942.42 per month, a meaningful increase of $1,492.89 per month. It is no wonder that housing prices are falling, and sales are slowing.

Throughout our careers, bonds had always provided downside protection when stocks did poorly, but after a 40-year bond bull market, bond prices have plummeted along with stocks. With all other things being equal, when interest rates rise, bond prices fall.

Consider this, the average coupon on a BBB corporate bond is now 5.95%. One year ago, the yield was 2.38%. This means that as interest rates have risen, the bond price on BBBs has fallen more than 20%. This is an extraordinary move.

An investor can value all businesses, including publicly traded ones, based on the present value of a future stream of earnings. For this example, as our discount rate, we will use the U.S. bank prime loan rate, which is now 6.25% compared to 3.25% one year ago. If we discount $100 per year in earnings over the next 30 years at 3.25%, we get a present value of $1,898.19 versus $1,340.43 at an interest rate of 6.25%. This is a drop in value of almost 30% and goes a long way toward justifying this year’s drop in stock prices.

Of course, these asset price drops are only the beginning. They have knock-on effects. When you buy a house, you also buy other products and services for the new house. When a company must pay higher interest rates on their debt, new potential expansion no longer makes financial sense. It also becomes more difficult to refinance maturing debt. Higher rates not only increase costs for businesses, but they are also likely to reduce revenue as the economy slows.

The Fed is likely to continue raising rates through year end. They may raise rates another 75 basis points or another 150 basis points. However, the numbers above argue for a Fed pause, sooner rather than later. It is hard to see rate increases going beyond 2022 because of the already substantial harm to asset prices.

The current value destruction may be enough to bring inflation inline as monetary policy works its way through the economy. Our economy needed higher interest rates. The economic animal spirits and the bubbling of asset prices was not sustainable. Our economic system certainly has boom-and-bust tendencies. They are alive and well. But history has shown us that this bust will eventually bring about the next boom.

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