Janet Yellen seems to be absolutely obsessed with increasing the benchmark interest rates in the USA as she desperately tries to put her stamp on her legislature as Chairwoman of the Federal Reserve. Even though the American economy definitely isn’t as strong as she thinks it is – the increases in employment are mainly due to part-time jobs which aren’t even sufficient to cover the costs of life – Yellen is determined to increase the interest rate which has been at a historical low since the Global Financial Crisis erupted (see next image).
This could have a devastating effect and in this article we will investigate the impact on a) the government finances and b) the stock market as a whole.
But first, allow us to start with a general remark. The past few chairmen of the Federal Reserve have always created their own crises during their tenure, only to try to solve those crises themselves to go out with a bang. Ben Bernanke said there was no bubble in the housing prices and a few decades before Alan Greenspan had to ‘solve’ the 1987 crash, only to create his own technology bubble in the 2000’s.
But, let’s go back to today’s situation. The Fed Funds Rate is at an all-time low and this results in lower borrowing costs for both the US government and the companies as the cost of debt is going down due to a lower risk-free interest rate. The interest expenses for the US government are now only marginally higher than 5 years ago, even though its total government debt has increased by 80% to $18T. The symbolic barrier of the government debt/GDP ratio of 100% has been reached a while ago, and now the risk of the snowball-effect is very realistic.
So, let’s keep it realistic and assume the total borrowing cost for the US government will increase by 1%. Nothing shocking, just one miserable percent. That’s absolutely not outrageous as the current interest on the 10 year government bond is 2.27%, but was more than twice as high in 2007, when it topped the 5%.
If the interest rate increases by one measly percent, the US will have to pay $180B in additional interest expenses. $180B. That’s approximately $560 per American citizen but as not every American pays taxes (kids for instance have no income and can’t pay taxes), it might be a more useful exercise to see what the impact would be per American.
According to the St Louis Fed, there are approximately 205 million Americans in the ‘working age population’ category. So if the US government would push the higher cost of debt on the taxpayers, a working American would have to pay almost $900 per year in additional taxes. And that’s just to cover the increased interest rate and doesn’t contribute a single dollar to reduce the government’s budget deficit.
The $900 per working person will have to come from somewhere, so it means the consumption pattern will change resulting in a lower purchasing power per person, lower demand for products and this a higher unemployment rate. A higher unemployment rate would mean those who still are working would see their taxes increase once again, and yes, a vicious circle is born!
And it’s not just the public debt that is worrying us, but the corporate debt is also on the rise. Due to the low interest rates, companies have issued a record amount of debt. Not to make smart and strategic acquisitions, no. The majority of the debt was used to reward their shareholders with special dividends and share repurchases.
Not only will that debt have to be repaid, it will very likely have to be refinanced as well. And yes, once the interest rates start to increase again, it will be much more expensive to refinance that existing debt. We tried to find out how much debt the S&P500 will have to repay before the end of this decade, and the results are shocking.
Source: JP Morgan and Bloomberg
As you can see on the previous image, S&P 500 members will have to refinance approximately $2.5 TRILLION in the 2016-2020 timeframe. So if the interest rate increases by 1%, it will cost them $25B in additional interest expenses. But as the interest rates on corporate bonds usually increases faster than on government bonds, the damage will be much higher. A 1.75% yield increase means the S&P 500 companies will have to cough up almost $45B in interest expenses. Per year.
Let’s single out one company as an example. According to the most recent balance sheet, General Electric has $250B in debt on its balance sheet. If the company would see the cost of debt increase by just 100 base points, it would result in an $2.5B higher interest expense. If you’d use an 1.75% higher cost of debt, General Electric would lose an additional $4.4B per year in interest expenses, resulting in a 25% drop in the pre-tax profit! And how do you think the market will react if companies would start to report double-digit net profit drops?
Our bet: Janet Yellen is so obsessed with increasing the interest rates she doesn’t look at the bigger picture. The profit increases at the stock markets will come to a screeching halt and once the increased interest rate trickles down to the corporate debt market, most companies will see their profits drop by a double digit percentage.
Our bet? Yellen will push the domestic economy over a cliff, will then do her best to save the world right before the end of her tenure to start a successful career in giving lectures, at $200,000 a pop.