WHAT HAPPENS TO FINANCIAL MARKETS WHEN INTEREST RATES RISE?

Surging inflation has forced central banks including the Federal Reserve to raise interest rates.  Their objective is to cool down the economy without disrupting normal activities in financial markets.  Interest rate increases initially impact financial institutions that borrow from central banks.  From there the increases are gradually passed on to other lenders in the chain as loans are repriced to higher rates.  But will financial markets hold up through this inflation tightening cycle? 

Existing Debt:  As rates go up for new debt, existing debt instruments have a tendency to decline in value as investors gravitate toward buying new debt instruments with higher interest payouts.  This could become disastrous to financial institutions that rely on borrowing on one end and lending on the other side.  When mark-to-market rules apply, financial institutions must write down the value of these existing debt instruments thus giving them a decline in the value of their capital.  A decline in capital can restrict the amount of money that these financial institutions have available to lend.  The decrease in the amount of money available to lend can push interest rates up to borrowers.  Higher rates to borrowers result in higher borrowing costs that may force cutbacks in the borrowers’ businesses.  Cutbacks in the borrower’s businesses can cause layoffs, reductions in sales, a general decline in demand, and recession.  Some of this is expected, as the overall economy needs to cool down to tame inflation.  Too much of it can cause a cascading economic disaster.

Stock Market Decline:  During the tightening cycle, stock markets are subject to selloffs as traders, investors, and large investment fund managers pause to decide what changes to their current strategies must take place.  The S&P 500 Index has declined from a peak on January 3, 2022, of 4,793 to a trough on October 12, 2022, of 3,577 (so far).  There is not a direct relationship with the announcement of inflation and the rise or fall of securities necessarily.  It’s more related to the market’s reaction to what is being done about it by fiscal policy makers and central banks.  Inflation was a known commodity last year in September, but Fed Funds rates didn’t begin to climb until the next Spring.  It was announced that the Quantitative Easing (expansion of the money supply) needed to be wound down first before interest rate increases would be positioned to fight inflation.  Every time the Federal Reserve’s Open Market Committee (FOMC) meets during a tightening cycle such as this one, there is a major amount of anticipation by investors as to how high interest rates will be raised, and not if they will be raised. 

Illiquidity In Financial Markets:  When illiquidity hits lending markets, the drop in the amount of lending can go all the way to zero.  Illiquidity is defined as not enough investment money entering the debt market for financial institutions to borrow.  As this can threaten banks’ existence, the central banks can be forced to step in and provide liquidity.  But doing so constitutes quantitative easing (increasing the supply of money) which is the opposite action that the central bank is attempting in order to combat inflation.  There is a latent fear in the industry that illiquidity will create insolvency in certain financial institutions as it did during the Financial Crisis of 2007/8.  When a financial institution’s assets are valued less that its liabilities, that institution is deemed to be insolvent.  If not rescued, the insolvent institution is likely bankrupt and will need the protection of a court to settle its dissolution. 

Protections for the Investor:  Since the Financial Crisis of 2007/8, a number of protections have been put in place to for the investor to rely upon when investing in financial institutions.  That crisis was driven largely by the bundling and re-bundling of mortgage-backed assets.  Banks in particular hold fewer real estate related assets today than they did in 2008.  This dials back their risk, but forces some banks to invest in lower yielding assets that pay less in return.  Further, there are limitations as to how much borrowing a bank can do versus raising capital from equity markets.  Other non-bank financial institutions have fewer restrictions and correspondingly more risk. 

Rising Corporate Debt:  Generally speaking, the greatest amount of risk during this tightening cycle may reside with corporations.  Many large corporations are into the debt markets regularly, and often roll their debt instruments over to new ones.  But rising rates cause the newer issues to also have higher rates, as investors seek better payouts.  The risks are also higher for corporations as the aggregate corporate debt has risen to 80% of GDP versus 65% in 2008, owing mostly to the prevailing ultra-low rates over the last decade.

Conclusions:  Monetary tightening cycles can be difficult to deal with, but their very presence is owing to a difficult overall economy that’s grappling with inflation.  There’s a high degree of uncertainty as to how to cope with it as debt investments are declining in value and stocks prices are volatile.  For the private investor, the best advice would be to stand pat and raise some cash whenever possible.  When the tightening cycle has run its course, some great investment opportunities, especially in fixed assets, will surface.

Sources:         The Economist, The Rumbling Draws Near, October 8^th, 2022.

                        Charles Schwab.