Federal funds rate signals big trouble ahead

Troubling developments are happening in the credit markets.

The federal funds rate is above 5%, close to where it was in 2007, the last time the economy started to tip into a major recession and financial crisis.

We are already starting to hear creaks and groans from within the markets.

Commercial property loan delinquencies are at five-year highs.

In May, more than 4% of office loans packaged into commercial mortgage-backed securities (CMBS) were at least 30 days in arrears.

This is leading to investors pulling out of CMBS, which is in turn driving up the price of borrowing.

Capital One, one of the country’s largest personal lending companies, has been raising concerns about credit card delinquencies since April.

It’s not alone: Delinquency rates are also rising for Discover and Bread Financial.

The rate of increase seems particularly high among those ages 18 to 29.

It isn’t hard to understand what has gone wrong.

During the lockdowns, the personal savings rate spiked to nearly 34%, by far the highest seen since the data began in 1960.

This enormous rate was driven by a combination of people staying at home and the cash injections the government pumped into the economy.

As inflation started to rise, partly due to lockdown-caused supply-chain disruptions, households rapidly spent down their accumulated savings to keep up with price increases.

Today the personal savings rate sits at 4.6%, far below the pre-pandemic average of 7.3%.

What the government gave with one hand, post-lockdown inflation took away with another.

Personal savings rates have been below the pre-pandemic average since winter 2021, when inflation started to take off.

With households having largely drawn down their savings, some have reached into the netherworld of credit card borrowing to make ends meet.

The delinquency data show this is coming to an end.

But all this is just the beginning. The reality is that high interest rates have only started to bite because many borrowers have not yet had to roll over their debt.

Oleg Melentyev, head of high-yield credit strategy at Bank of America, has recently done an interesting calculation.

He notes global interest rates have risen from 1% in 2021 to around 4% today, yet because many borrowers have not had to roll over their loans, the average interest rate has only reset 0.5%.

If all interest rates are eventually forced to reset to take account of the actual 4% interest rate prevailing in the market, Melentyev points out, it will cost borrowers across the world around $8 trillion.

That’s equivalent to the gross domestic product of Germany and Japan, the world’s third- and fourth-largest economies, combined.

The underlying problem here: Most developed countries’ debt load remains enormous.

After the 2008 financial crash, there was much talk about the need for deleveraging.

Fifteen years later, we can say with confidence that deleveraging never really took place.

In the United States, household debt peaked at around 98.2% of GDP in mid-2009 and today stands at only 72.3%.

Business debt, however, has risen in the same period from 73.7% of GDP to 75.4%.

Overall private-sector debt has fallen from its peak of 234% of GDP to 218% today.

If this is deleveraging, it is not very meaningful.

Sustained deleveraging did not take place because the Federal Reserve used quantitative easing and other unorthodox monetary tools to suppress interest rates and prop up borrowing.

But with interest rates rising, the system is coming under a severe real-life stress test.

There appear to be only two ways out.

Either the Fed continues to raise rates or keeps them at the present levels — in which case the financial system is almost certain to experience a crisis.

Or the high interest rates lead to a recession that is not accompanied by a financial crisis — and the Fed responds by going back to QE and other measures to try to get the economy rolling again.

We seem to be stuck in a never-ending credit cycle.

The Fed makes out as if it controls a thermometer that allows it to warm up the economy when it is cold and cool it down when it is hot.

But the reality is more like an intravenous line hooked straight into the veins of the economy, where the Fed injects stimulants when the patient starts to fade and tranquilizers when he gets too jittery.

It’s not hard to imagine what such “therapy” does to the patient’s body.

The American economy is wrenched one way or another, unstable and unable to find its bearings or make long-term investment decisions. This is bad medicine indeed.

Philip Pilkington is a macroeconomist and investment professional.