The Road to Higher Rates has Multiple Pathways and None are Good
Posted at 25 Sep by Shalin

In my previous note, I posted a chart of US Corporate Borrowing Rates since the early 1970’s. It is one of my favorites and rare is a comment from me where it won’t be mentioned. I firmly believe the interest rate/credit cycle is the end all be all for all macroeconomic forecasting and anybody who ignores it does so at their own peril. Below are some interesting takeaways every investor should note.

The pathway to higher rates in higher baseline interest rate environments is typically a function of policy. That sort of environment describes the 1970’s and early 80’s recession, which were really about inflation rather than excessive valuations or leverage.

On the other hand, the pathway to higher rates in lower interest rate environments is increasingly a function of risk appetite the lower baseline interest rates are. This sort of environment describes the 2008 financial crisis where despite aggressive rate cuts by the Federal Reserve, borrowing rates among even the safest corporate entities rose. Some refer to this phenomenon as “pushing on a string.”

Currently, what we are witnessing in rates is quite orderly, albeit within an extremely prolonged rate cycle that echoes other rate hiking periods such as 1999/2000 and 2005/2006. Indeed, in observing those periods as well as prior cycles, it has usually taken about a 200bp peak to trough rise in corporate borrowing rates to definitively slow down the economic cycle and push corporate profits (if not the economy) into a recession. Most recently, high-grade borrowing rates bottomed in July 2016 at ~2.75%. Ostensibly, this means they could rise as high as 5% before catalyzing the next downturn.

But this is where it gets interesting. Rate hikes today lay the catalysts for the next downturn, which inevitably will mean an increase in (drum roll) risk aversion. The questions then become, how quickly can the Federal Reserve get ahead of the risk aversion curve and does the Fed have enough firepower to mitigate the downturn?

Before I render my opinion, below is monetary policy during the last three big economic cycles in the US.

As you can see, it has taken an increasingly unconventional policy to mitigate economic crisis. I have no doubt the next crisis will again need to be met with a zero or even negative rate policy, as well as some form of Quantitative Easing. I also have little doubt that the next crisis will be quite severe due mostly to the inability of the Fed to catalyze a major refinancing cycle.

The implications of a muted refinancing cycle are profound. Every time ‘we’ thought it couldn’t get crazier, Fed policy extended the day of reckoning. This is nicely captured in the 5-year rolling borrowing rate, which shows that from the early 1980’s to the financial crisis, there was almost never a 5 year period which saw higher borrowing costs. In a nutshell, that era is over.

There are a handful of takeaways here:

Nearly every asset class today, from education to art, has in my opinion been underpinned by the low rate paradigm.
Within this framework, it becomes painfully obvious the US economy is very late-cycle here. But crazy things can happen in late-cycle economies, as risks and rewards become amplified, and betting on bear markets too early can be a costly mistake.
Interest rates will likely peak around 3.5%, which corresponds to the requisite 200bp increase in corporate borrowing rates necessary to end the economic cycle.
Having an open-minded tactical approach is key at this juncture of the economic cycle. Liquidity wouldn’t hurt either.

All data for this note was sourced from Bloomberg.

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