The U.S. Federal Reserve (“Fed”) has often used monetary policy as a tool to moderate economic growth, whether it was to bolster or curtail the growth rate. One key monetary policy tool is the adjustment of the federal funds rate, which had been lowered and kept drastically low in recent years as the “cure” for an ailing economy or to boosting or maintain economic activity. The federal funds rate was above 4.00% in 2007 before the financial crisis caused an economic shock wave that resulted in an average unemployment rate of 9.4% between 2008 and 2009.1 The federal funds rate started climbing again in 2017 before the Fed lowered rates back to near 0% in response to Covid-19. Generally, interest rates were accommodative for much of the 2010s and that benefitted the economy, but not without long term consequences that are now materializing.
The Cure: Low Interest Rates Lead to High Savings Rates
- High Savings Rates
The average annual seasonally adjusted real personal savings rate was 4.02% between July 2004 and December 2019.2 A federal funds rate near zero for most of the period likely contributed to higher savings rates because consumers could borrow at favorable payment terms and be more efficient with their money by refinancing higher cost liabilities, for example.
The Poison: Higher Inflation Erodes Savings
In 2022, we are finally seeing negative economic effects - a combination of low interest rates and supply chain shortages bolstered inflation to levels not seen since 1982.
Higher than expected inflation reduced the average annual seasonally adjusted real personal savings rate to -2.99%3 in 2022, a 9.35% decrease from the average between 2009 and 2021. Savings erosion has likely contributed to maintaining current consumption trends, and supporting inflation, but probably at the expense of future consumption.
The Cure: Low Interest Rates = Lower Mortgage Financing Costs
The average weekly U.S. 30-year fixed mortgage rate between 1999 and 2008 was 6.53%, almost 30% higher than any average weekly U.S. 30-year fixed mortgage rate of 4.00% between January 1, 2009, and December 31, 2021.4 Consumers were able to borrow more money when mortgage rates were lower because their income could satisfy the principal and interest payment.
The Poison: Higher Mortgage Payments
Many people were able to borrow more absolute dollars to buy a home when interest rates were lower. Targeted monthly mortgage payments (principal and interest) were established with larger amounts borrowed, which bid home prices up. More absolute dollars borrowed can become more expensive when refinancing expiring mortgages, or for those with adjustable-rate mortgages once interest rates increase.
In 2022, for example, the average weekly U.S. 30-year fixed mortgage rate was 4.86% compared to 2.96% in 2021.5
The average monthly payment for someone with a $400,000 mortgage, amortized over 30 years would have increased by about $435, or more than 26%, between 2021 and 2022. Higher mortgage payments put a strain on personal savings rates and disposable income required for other goods and services.
The Cure: Low Interest Rates Support Higher Fixed Income and Equity Valuations
The chart above illustrates the generally inverse relationship between bond prices and interest rates. More importantly, the interest rate level used as the discount rate, applying the fitted yield in the 10-year zero coupon bond as a proxy6, was an average of 2.16%, which assisted the S&P U.S. Treasury Bond 20+ Year Index to increase by 46.67% between August 31, 2012, and December 31, 2021. Equity markets have often performed well during low interest rate environments for two main reasons:
Companies issued bonds at low interest rates which resulted in low financing costs compared to issuing bonds in higher interest rate environments. Low debt service costs typically supported higher net income and earnings per share compared to periods with higher debt service costs.
Consumers borrowed at low interest rates which resulted in accommodative principal and interest payments. This suggested higher levels of disposable personal income that could be spent on goods and services that benefited corporate top line revenue.
Higher personal disposable income from low interest rates generally supported stock prices with the S&P 500® Index increasing 411.50% on real disposable personal income appreciation of 31.79%, between January 1, 2009, and December 31, 2021.
The Poison: A Higher Cost of Corporate Debt Refinancing
Corporations often roll over their fixed income into new bonds or preferred shares upon maturity. Many corporate finance decisions favored to increase their overall debt burden during periods of low interest rates. Higher debt levels can expose many corporations to increasing debt service costs when their existing fixed income liabilities mature and are rolled over in higher interest rate environments.
Higher debt levels7 and subsequently higher debt service costs8 can erode profitability. Additionally, higher debt levels and higher debt service costs could weaken firm valuations and widen the corporate bond spread, further exacerbating liabilities if their debt is downgraded.
The economic cure of low interest rates over the past decade had provided many with the opportunity to borrow, save, invest, and spend with little consequence as debt service payments and inflation remained accommodative. Low interest rates also supported high bond valuations and resulted in lower equity cost of capital for equity valuations.
Many economists believe that low interest rates can be a good time to pay down debt, not take on additional debt. By paying down debt, consumers can position themselves for periods when interest rates are higher. However, we have seen consumers take on more mortgage debt in recent years. Higher interest rates and persistently higher inflation since 2021 has simultaneously strained personal savings, fixed income, and equity valuations. We will likely have to wait until 2023 to see if the cure that became the poison can be cured by other means.
2 Savings rates between March 2020 and March 2021 were skewed upward because the Covid-19 pandemic not only caused significant economic uncertainties, but the lockdown also created an inability for many to spend as they normally would while simultaneously receiving fiscal transfers, including stimulus checks and unemployment benefits.
3 Source: U.S. Bureau of Economic Analysis, Personal Saving Rate, retrieved from the Federal Reserve Bank of St. Louis
4 Source: Freddy Mac, weekly data ending Thursday, between January 1, 1999, and December 31, 2008.
5 Source: Freddy Mac, weekly data ending Thursday, between January 1, 2021, and September 29, 2022.
6 The S&P U.S. Treasury Bond 20+ Year Index likely includes bonds that have varying coupon rates and, therefore, may be valued at a premium or discount to par. The Fitted Yield on the 10-Year Zero Coupon Bond was used as a discount rate proxy to remove the coupon rate variable and to isolate the interest rate used as the discount rate.
7 The source in the chart includes U.S. commercial paper, mortgages, depository loans (excluding mortgages), corporate bonds and other forms of debt issuance. Depository loans are loans from banks, credit unions, and savings and loans associations. Other includes loans from nonbank institutions (excluding mortgages) and industrial revenue bonds.
8 The Moody’s Aaa Corporate Bond Yield was used to determine the debt service cost.
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