The biggest and fastest rate-hiking cycle in the last 40 years, raising the federal funds rate by 5.25% from March 2022 to July 2023, was widely expected to cause a recession in 2023. However, real gross domestic product (GDP) growth unexpectedly accelerated from 1.9% in 2022 to 2.5% in 2023.
So why is the economy so resistant to these rate hikes?
We see four main factors behind this:
Households have built up surplus savings during the pandemic and businesses have increased their cash holdings, which are now being spent. Many borrowers are locked into low interest rates on mortgages and corporate bonds, which have kept interest costs low. Risk asset prices have remained robust, compressing risk premiums. Reductions in risky shadow banking activities (activities outside the traditional banking sector) have made the financial system less vulnerable to shocks.
It's important to note that the first two factors are entirely temporary, and the third is only partially temporary, so we believe aggressive rate cuts by the Fed will still be necessary over the next few years to avoid a recession.
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We explain how these factors have contributed to the economy's resilience and what is expected to happen going forward.
Households have turned their excess savings into cash, but it is now being spent.
Household savings and net lending surged in 2020 and 2021 due to fiscal support and spending restraints caused by the pandemic.
People put much of their excess savings into cash: Household cash holdings (which include deposits and money market mutual funds) rose to 77% of GDP at the end of 2021, up from 61% at the end of 2019. By the end of 2023, that share had fallen to an estimated 66% of GDP as these excess savings were spent.
Net debt issuance increased in 2021 and 2022 as households' accumulation of cash-like assets increased more than the surge in net lending. That is, households used their excess savings to pay down credit cards and other debt (at least initially), but this was more than offset by a home-buying and cash-out refinancing frenzy.
Still, government issuance remains well below levels seen in the mid-2000s.
If interest rates do not fall, mortgage interest payments will steadily increase.
Average interest rates on household debt in 2023 were roughly in line with pre-pandemic levels. Because most household debt consists of fixed-rate mortgages, which are not impacted by rising interest rates, market mortgage and auto loan rates in 2023 were significantly higher than pre-pandemic, but the interest rates paid by the average borrower have only increased gradually.
In the non-mortgage securities category, maturities tend to be much shorter and the debt (such as credit cards) is often at variable rates, meaning that average interest rates are adjusting more rapidly. Most non-mortgage debt should be rolled over to market rates within the next five years.
That said, unless interest rates fall, home prices across the nation appear to be overvalued. Lower interest rates would eliminate much of this overvaluation, but we believe that if interest rates remain high, real home prices are more likely to fall slowly rather than crash.
For companies, the surge in interest rates beyond pre-pandemic levels has put their financial health at risk. Many companies increased their leverage over the past decade, but interest rates remained low so the interest burden was easily manageable.
Large public companies with long-term fixed-rate debt have their interest rates locked in for years, but commercial real estate appears more vulnerable: This debt has a much shorter maturity, and if interest rates remain high, commercial real estate prices are likely to fall further.
Risk premium shrinks
In theory, as real interest rates rise, the prices of risky assets should fall.
But that has hardly happened this rate-hiking cycle, whether in housing, commercial real estate or stocks.
Housing: As mentioned above, most mortgages are fixed-rate, so new issues will have higher interest rates, but it will take longer for the market as a whole to reflect these higher rates. Commercial Real Estate: If interest rates do not fall, commercial real estate will be the biggest financial risk in the business sector within the next 2-3 years. Commercial real estate has a shorter maturity than corporate debt, so interest charges will rise faster. If interest rates remain high, the only realistic way that the cap rate spread (commercial real estate cap rate vs. real 10-year Treasury yield) can normalize is if real values fall substantially, which would require a shocking 40% drop relative to average levels in 2023. Equities: Equity market valuations, as a whole, do not appear to be adversely affected by rising interest rates. The spread between equity earnings yields and real 10-year Treasury yields has narrowed to around 2% versus 4.6% in 2019. Still, there is some risk of a reversion to the spreads seen in the 2010s, which would pose a threat to stock prices if real interest rates remain high.
This graph shows that the income yields on various risky assets have remained broadly stable and in line with asset prices.
The chart shows that spreads over real 10-year Treasury yields have narrowed, and risk premiums have generally declined. Credit spreads have responded strongly to rising interest rates, but remain low compared to historical averages.
The shadow banking threat is largely dormant
Shadow banking credit refers to lending from non-bank institutions engaged in large-scale risk transformation. The expansion of shadow banking credit to the private non-financial sector rose from 30% of GDP in 2000 to 51% in 2007 and was a major cause of the collapse of the financial system in 2008.
As the graph below shows, shadow banking credit falls to 22% of GDP as of 2023, meaning the financial system is less vulnerable to shocks such as rising interest rates.
Thus, not only has the private sector become less leveraged compared to the mid-2000s, but the riskiest financial intermediaries have also experienced the greatest decline.
As a result, the U.S. financial system is in a strong position, barring any imminent monetary tightening.
What will happen to interest rates in the future?
We still believe the Fed will need to cut rates aggressively through 2024 and 2025.
We expect the federal funds rate to fall from a target range of 5.25%-5.50% as of April 2024 to 1.75%-2.00% by late 2026. Similarly, the 10-year Treasury yield will fall from 4.60% as of April 2024 to our longer-term forecast of 2.75% after 2026. Essentially, we expect interest rates to return to roughly their pre-pandemic three-year average.
Our Economic Forecast
But what if the Fed makes very few rate cuts over the next year or two, as some forecasters have predicted and as markets seemed to have priced in some time ago?
Private sector finances are not structured to withstand a permanent increase in interest rates relative to pre-pandemic levels: balance sheets are too large and asset prices too high to accommodate the new normal of higher interest rates. These vulnerabilities have not yet materialized, but they will eventually if interest rates remain high.
In other words, most of the contractionary effects of the Fed's rate hikes have yet to be felt.
Therefore, if the Fed is unable to cut rates as quickly as we expect, a sharp recession is very likely. Ultimately, a recession would cause interest rates to fall sharply to our expectations, or even slightly lower in the near term.
This article was compiled by Emelia Fredlick.