This Time Isn’t Different

This has been the only economic cycle where a tightening of monetary policy has not led to corporate interest expense rising too. When the Fed began raising rates in March 2022, corporate net interest payments as a share of profits was almost 30%, as illustrated in the chart below. As the Fed funds rate continued to increase, net interest payments continued to fall. Presently, they are under 10%, which is the lowest share since the mid-1960s. This has never happened before and is clearly a factor explaining why the economy has not slowed as much as a substantial increase in the funds rate would imply a priori. What happened?

Given the severity of the 2020 recession which resulted in both a zero percent fed funds rate and firm Fed guidance that rates would remain low, many companies locked in historically cheap debt. Corporate bond issuance grew by nearly $800 billion in Q2 2020 from four quarters earlier, a record amount that was $300 billion above the previous all-time mark. This meant that many companies were inoculated from higher interest rates well before the Fed began tightening.

Then as the Fed began raising rates, companies began earning more interest on their institutional money market and treasury accounts. In effect, the inverted yield curve (defined as the spread between 2- and 10-year Treasury yields) has been net stimulative to the corporate sector because it is earning interest above what it is paying out in interest to its bondholders. Notice how the net interest expense as a share of profits has continued to decline while the curve remains inverted. The dampening effects of higher fed funds have been blunted. But this does not mean that monetary policy is ineffective or that it will not ultimately slow the economy.

Corporate debt will eventually need to be refinanced but more importantly, household borrowing costs are at a two-decade high. Elevated automobile, credit card, mortgage and personal loan rates may be starting to pinch consumers, which is evident from the latest Federal Reserve Bank of New York data for Q1. Automobile loans and credit card delinquencies are at their highest readings since 2011. This is troubling considering that the unemployment rate is under 4% compared to 8.9% in 2011. What happens if the labor market softens in the months ahead?

Absent a sharp decline in interest rates, the upward trajectory in household delinquencies may continue with obvious negative implications for future consumption. In this regard, the “no landing” and “soft landing” enthusiasts should not become overly confident that monetary policy does not have potency or that this time is different.

Disclaimers

This document is provided by SMBC Group (including, collectively or individually, Sumitomo Mitsui Banking Corporation, SMBC Nikko Securities America, Inc., and their affiliates, as applicable) for informational purposes only, solely for use by the client(s) or potential client(s) to whom such document is directly addressed and delivered. This document was prepared by SMBC Group’s economist(s).? ?

This document has been prepared for and is directed at institutional investors and other market professionals, and is not intended for use by retail customers.? It does not take into account any specific investment objective, financial situation, or particular need of any recipient.? The information contained herein should, for whatever purpose, be used solely at the discretion and responsibility of the recipient. SMBC Group does not accept any liability or responsibility for any results in connection with the use of such information.? Recipients are responsible for making final investment decisions and should do so at their own discretion following their own independent analysis and assessment of the merits of any transaction prior to execution, after conducting a careful examination of all documentation delivered, explanatory documents pertaining to listed securities, prospectuses, and other relevant documents. The financial instruments discussed may be speculative and may involve risks to principal and interest.

Conflicts of Interest Disclosures

The views, statements, assumptions and forecasts expressed herein may differ from those expressed in globally branded research produced by SMBC Group. The trading desks of SMBC Group trade or may trade as principal in the financial instruments that are the subject of this material, and the author(s) of this document may have consulted with the trading desks while preparing this document. The proprietary interests of SMBC Group may conflict with those of the recipient.? SMBC Group may seek to do business with the companies mentioned in this material and the trading desks may accumulate, be in the process of accumulating or have accumulated, long or short positions in the financial instruments mentioned and may have acquired them at prices no longer available. The trading desks may also have or take positions inconsistent with the views expressed in this document or may have already traded on those views.?

This material is not a research report, and neither this material nor its author(s) is subject to policies and procedures that apply to the globally branded research reports and research analysts of SMBC Group or to legal requirements designed to promote the independence of investment research. It is not subject to any prohibition on dealing ahead of the dissemination of investment research. This means that on the date of this document, SMBC Group, and its directors, representatives, or employees, may have a long or short position in any of the instruments mentioned in this document and may make a market or trade in instruments economically related to the securities, derivatives or other underlying assets mentioned herein, in each case either as principal or as agent.

No part of the author(s) compensation was, is, or will be, directly or indirectly related to the specific recommendations or views expressed herein. The personal views of authors may differ from one another.

?This document is the property of SMBC Group, subject to copyright. Any reproduction of this document, in whole or in part, is prohibited, and you may not release this document to any person, except to your advisors and professionals to assist you in evaluating the document, provided that they are obligated, by law or agreement, to keep the document confidential. Distribution, possession or delivery of this document in, to or from certain jurisdictions may be restricted or prohibited by law. Recipients of this document are required to inform themselves of and comply with all such restrictions or prohibitions.

? 2024 SMBC Group. All rights reserved.