I’ve started paying closer attention to interest rates.
The motivation: my trusty mortgage ARM — which hovered around 3% for a decade or so — jumped to 4% last year and is being reset to 5% this year.
Ouch.
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That got me wondering about the the impact of rising rates on the Federal budget…
Ok, the Fed finally hiked rates by a whooping 1/4% ….
A common view: “geez, is the economy so bad that it can’t absorb a measly 25 bps increase in interest rates?”
Obviously, .25% isn’t enough to sway many corporate investment decisions … most corporate investments are projected to return mucho above the firm’s cost of capital … not mere quarters of a point. Reality is that firms have hurdle rates way above their cost of capital, reflecting implicit risk and organizations’ limited implementation capacity.
So, what’s likely to be the major impact?
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Here’s my take…
Last week’s Federal Reserve action (err, make that inaction) caused a stir in the financial markets.
Common view was: ” geez, is the economy so bad that it can’t absorb a measly 25 bps increase in interest rates?”
In yesterday’s post, I put the number in context, illustrating that the economic cost of a measly .25% just on servicing the national debt is about $45 billion ( .25% times $18 trillion) …. equivalent to roughly half of the Federal government’s annual cost for ObamaCare.
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Today, let’s take a couple of more views of the 1/4 of 1 % …. the impact on household incomes.
Last week’s Federal Reserve action (err, make that inaction) caused a stir in the financial markets.
Common view was: ” geez, is the economy so bad that it can’t absorb a measly 25 bps increase in interest rates?”
Obviously, .25% isn’t enough to sway many corporate investment decisions … most corporate investments are projected to return mucho above the firm’s cost of capital … not mere quarters of a point. Reality is that firms have hurdle rates way above their cost of capital, reflecting implicit risk and organizations’ limited implementation capacity.
So, what’s going on with the Fed’s decision?
Some pundits are arguing that the Fed is just trying to prop up the stock market with low rates that force investment into higher risk intruments (i.e. stocks)..
That may be true, but it doesn’t seem to have done the trick last week.
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I think that there’s something else going on … something that I haven’t heard from any on-air pundits …
I was a bit surprised to hear on the news that Citi was laying off a couple of thousand folks in their mortgage division.
After all, there’s been lot of talk re: housing recovery … with some markets el fuego.
Hmmm.
Turns out that mortgage applications bottomed out after the meltdown …and arguably showed some up-trend in the past couple of years (thanks to the Fed QE program),
But, mortgage apps have declined recently (as interest rates started moving up a bit) and are hovering at very low levels
What about home prices?
Liberal economists say not to worry since interest rates are so low … take all the cheap money you can get.
So, the Feds have been piling on debt … at an average cost of about 2%.
Doing some arithmetic, the cost to service the debt is about $350 billion annually … about 10% of Federal spending.
Here’s the rub …
About half of the debt is short-term … less than 3 years.
Source: Strategic Research Partners
So what?
What if interest rates were to jump back to more historical levels …. say 6%.
Boom.
Suddenly, servicing the debt would have an annual downstroke of over $1 trillion.
Makes the Sequester look like a walk in the park, doesn’t it?
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Here’s a chart to calibrate your perspective …
The Fed Funds Rate currently running at about zero … that compares to a historical average of about 8% … and a peak of about 18% in the Carter years.
There’s only one way to go – up.
Imagine the fiscal crisis if if the interest rate on the $16 Trillion debt slides back up to the 8% historical average … or, gawd forbid, to the Carter-level rates.
Now, that would be a fiscal cliff !
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