FOMC Decision Day

and a message from Powell

The FOMC made their announcement today. They continued to push the Fed Funds Rate up by 75 basis points. This is the third time they’ve raised rates by 75 basis points since June. Powell and Co are raising the cost of capital and in time, this will really hammer businesses that are dependent on rolling over their loans. “Rolling over” is fancy business speak for refinance. Here’s what I mean:

For the last 40 years, we have seen an environment of constantly lower interest rates.

When a company has taken out a loan during this period, it has been able to refinance that loan at a lower rate. Companies began getting in the habit of borrowing money, and then refinancing over and over again. These businesses would often go back and borrow more. By utilizing this strategy, there were two primary impacts. First, businesses used that borrowing to fund new developments, business expansion, and stock buybacks. Second, by constantly rolling over their debt, they were able to inflated their earnings because their interest costs would decrease because they were refinancing at lower rates.

It works the same as a mortgage home loan. Here’s an example:

Say you bought a house in 1982. The average 30 year fixed rate in September of that year was around 15.4%. If that house cost $100k, you would be paying $1,296.49 per month. Five years later in 1987, mortgage rates dropped to 11%. Refinancing would lower your payment to $952.32. That is a 26.5% reduction in mortgage costs. Five more years go by, its 1992 and interest rates are now at 8%. Your payment goes down to $733.76, a 23.0% reduction from 1987’s payment amount. By September of 2002, interest rates were at 6%. This would have pushed the payment down to $599.55, an 18.3% reduction from the 1992 figure and a 54.0% reduction from the original payment amount.

Now this looks great when interest rates are going down but what happens when this goes in reverse? As the cost of borrowing increases companies will be unable to refinance their debt. Their interest costs will rise and company earnings will become deflated. The days of funding stock buybacks with borrowing capital will be over. New developments and business expansions will slow.

There are going to be a few companies out there that will be unaffected by these developments. They’ll be the ones who have locked in long-term low rates for borrowing and have put this capital to good use expanding business in a health manner. There will be others who will pay off their debt with their free cash flow. These companies will have high current or quick ratios and low long-term debt to equity ratios. Then there will be companies that will be heavily affected by the cost of capital rising. These will most likely be companies with high debt loads, growth companies that depend on increasing amounts of capital to expand, and companies that are unprofitable.

Don’t expect investors to figure this out overnight. This will be a theme that plays out over a long time frame. In addition, the market is still not taking into account the reduction in liquidity. M2 money supply has been flat. My prediction is that it will continue to stay flat. Also, many participants still believe that the Fed will pivot at any moment and they don’t want to miss the tremendous upside when it happens. Breaking news, I don’t see a pivot happening any time soon.

Powell is sending a message. He and the big banks run the show. They want to suck dry the euro-dollar market. When the euro banks were caught manipulating LIBOR, it came to the Fed’s attention that they were not in full control of monetary policy and they want that control. By breaking with LIBOR and using SOFR, they now have that control and they intend to have payback. If you missed it, Powell also sent a message to Congress. At the Cato Insitute’s 40th Annual Monetary Conference, Powell told Congress to get their fiscal house in order, because “history cautions strongly against prematurely loosening policy”.

It is highly unusual for a Fed member, let alone the chairman, to talk about fiscal policy. Powell knows that monetary policy can only go so far in combating inflation. The other half, fiscal policy, also has to be in lock-step if inflation is to be curtailed. This is the same playbook that Volcker used. He needed Congress to rein in their spending while he raised interest rates in order to reduce inflation. Powell has declared himself to be the next Volcker. It is only logical that he will follow a similar path. Congress needs to know, the days of reckless spending are done. It is time to tighten budgets. They would be wise to listen to Powell but spending money is a way of life for most in Congress. They will have a hard time stopping.