July 15, 2022

The Real Cost Of These Higher Interest Rates

As one pundit put it, Americans have become used to free money. And it is true. Since the Great Financial Crisis of 2008, it has been the policy of the Federal Reserve to maintain near-zero interest ratesFree money, if you will. So why not borrow as much as you can? That at least seems to be the mantra of many.

And it has been hard to argue against that thinking.

That is until today. And now, as the cost to borrow becomes higher, it is evident that it’s payback time. As we’ve expected, those formerly low-interest loans are seeing a significant hike in monthly payments. By my best estimate, the average consumer short-term loan will likely see its interest rate double this fall.

The reasoning is a little complicated, but it goes like this. The Fed Funds rate, established by the Federal Reserve, currently stands at 1 1/2%. Next week and then again in September, the Fed will decide whether to raise interest rates. Almost everyone believes they will increase the Funds Rate by 3/4% at each meeting.

That’s a rise of 1 1/2% plus the current rate, giving a base interest rate in the nation of 3% and doubling today’s rate.

So, here’s what that means in real dollars. Suppose you are one of the very best large corporations in the country, with outstanding credit. Last year at this time, banks were all over themselves offering to make you a loan, at about the low end of interest rates then, 1/4%. You like that rate, so you borrow $100,000 at 1/4%. The cost per year? Only $250, an excellent deal indeed.

Now let’s look forward to where I think interest rates will be this fall. Again, assume you have the very highest credit score. This time, however, you find that your local banker isn’t all over you offering a loan. Not at all. You must fill out form after form before he’ll even discuss what loan he’ll give you.

And this isn’t a joke. We’re going to find that as this cycle progresses, the bank lending policies will get stiffer and stiffer. And what was an easy loan to qualify for is going to become much more difficult.

We saw this yesterday when the nation’s largest bank JP Morgan Chase reported its latest results. Buried in that report was a note that they intend to set aside nearly a half billion dollars for bad loans. So you can bet your bottom dollar they’re going to take every precaution not to make a bad loan to you or me.

But let’s continue with our story. Flash forward to next fall, and again you have been given a $100,000 loan same amount as before. Only this time, a couple of additional items appear in the loan contract. You may, for instance, have to guarantee the loan personally. Or provide audited financial reports. All to make sure your loan will perform.

But that’s not all that’s changed. The yearly interest has gone from $250 to $3,000 per year. This new rate is 12 times higher than before!

I know it’s almost impossible to believe. So let’s check the math. $100,000 at 1/4%, yep, just $250. $100,000 at 3%, yes sir $3,000.

So let’s step back and look over all this from a big picture perspective.

The projected interest rate move by the Fed will all by itself be enough to crush many people. And as JP Morgan is signaling, by their jump in loan loss reserves, many are not going to be able to make these much higher interest payments.

And remember, our example was an interest-only loan. Instead, most are fully amortized loans, so the actual payment difference will be more significant than our example.

But we’ve been in this credit cycle squeeze before. Once the banks start hurting because of those missed loan payments, they will immediately begin raising loan requirements and asking for additional collateral or guarantees. For many, it will become hard to qualify for a loan when they need it the most.

The credit crunch will have begun. The financial system will have a tremendous amount of debt, with limited collateral and even shakier income to service all that debt. And we will be right back where we were in 2008.

And at that point, we may finally realize that the Financial Engineers have run out of tricks. The Zero Interest Rate Policy, the Quantitative Easing, and the Modern Monetary Theory will all run their course.

And at last, it will be “Payback Time.”

Economic News

Today we get a close-up look at the American consumer with two reports, the closely watched Retail Sales and the Michigan Survey of Consumer Confidence.

These will both be the reports for June.

Looking back, the May report for Retail Sales was negative for the third time in the last 12 months. Today Wall Street will focus on the resilience of the consumer, as the Street is looking for a slight increase in sales this morning.

A little later this morning, the University of Michigan reports its latest results on Consumer Confidence. And it’s here that we may see yet again a record. Not a good record. Last month, the Michigan survey came in at an all-time record low. Indicating that Consumers are non too happy about current conditions. The Street expects that will continue with this month’s report.

In earnings, it’s the next two of the big four banks: Citigroup reporting this morning and Wells Fargo later this afternoon. The big number to focus on will be the loan loss reserve for these banks. After a couple of years of lowering reserves, these two banks, plus US BancorpPNC Financial and Bank of New York Mellon, and State Street Bank also reporting today. IF all those banks start raising loan loss reserves, it’s likely that they are looking at recession just ahead.

Also reporting from the financial sector will be investment giant Black Rock, with United Health Care as the loan nonfinancial company today.

Please follow me here on ValueSide.com for more stories on Interest Rates and Inflation.

David