Thoughts On ... Is the Fed actually stimulating the economy?

July 07, 2023 | Matt Barasch


Is the Fed Actually Stimulating the Economy?

Let’s put this in the category of thinking out loud. Let’s start with a chart and then comment:

Here, we are looking at household money market funds in the U.S. As you can see (and not surprisingly), the level of money market funds has gone somewhat parabolic in recent months as the Fed Funds rate has pushed past 5%.

Now, let’s think about this for a moment – at the beginning of 2022, there were ~$2.6 trillion in money market funds. At that time, the average money market rate was ~0.5%, meaning that these funds generated about $13 billion of annualized cash flow. Considering the U.S. economy is ~$20 trillion and is growing nominally at about 5% (or ~$1 trillion) per year, $13 billion does not amount to all that much (about 1.3% of nominal growth). In other words, cash flow from money markets in early 2022 was not going to move anyone’s needle, let alone a needle the size of the U.S. economy.

Okay, now let’s fast forward to today – household money market deposits are up to ~$3.2 trillion, while rates on money markets are up to ~5%, meaning that these funds now generate ~$160 billion of annualized cash flow, which amounts to ~16% of nominal GDP growth. In other words, cash flow from money markets in 2023 can move a very big needle.

Okay, but the obvious response might be – yeah, that’s great, but if borrowing costs are also skyrocketing, consumers are no better off – and considering how clever banks are, consumers are probably getting squeezed harder on the borrowing side than they are making back on the money market side. With that in mind, let’s look at another chart:

Here, we are looking at current fixed mortgage rates in the U.S., which have gone from 3.1% at the beginning of 2022 to 5.3% currently. To put this in perspective, a $500k mortgage would cost ~$900 more per month if taken out today vs. at the beginning of 2022. However, as you can see, the blue line, which is the average rate on all U.S. mortgages, has barely moved. This is because, according to the Dallas Federal Reserve, ~96% of all U.S. mortgages are fixed rate with the vast majority of these locked in for 25-30 years.

Let’s add another chart that tells a similar story:

The chart above points out that ~70% of all mortgages in the U.S. are locked in below 4% with very little movement in this percentage since rates rose, which speaks to that 96% number from the Dallas Fed.

Putting it All Together for Consumers: So, if you take the two above, the cash flow side has seen a ~$150bn injection from higher money market rates, while the liability side has not really felt much of an impact. With the Fed set to raise rates at least another 50bps and the likelihood that money market rates will move higher still – this has the potential to perversely add even more stimulus to the economy.

The Flipside

Okay, but this is obviously not all champagne and red roses. With mortgage rates north of 5%, this is going to have two big impacts on the U.S. housing market: 1) new home buyers are going to be priced out of the market; 2) home owners are effectively going to be unable to move because most mortgages in the U.S. cannot port from one home to another (unlike Canada), so, if you want to move and you have a mortgage on your existing home, you are looking at a massive increase in borrowing costs should you choose to move, as you are going to have to negotiate a new mortgage.

This has led to another somewhat perverse outcome, which is that despite the sharp run-up in mortgage costs and the general slowing of the economy, house prices have begun to rise again as there is simply not enough inventory to meet demand, even though demand is down.

One last point on housing – it is vitally important to U.S. economic growth – accounting for between 15% and 20% of GDP, making it the single largest component. Thus, while firm pricing is a positive, a general lack of activity is not, which could be a continued drag going forward.

What About the Business Side?

While I think you can make a plausible case that the Fed is actually helping the consumer right now, the business side will not have the same tailwinds largely because businesses can generally not lock in their debts for 25-30 years. However, while the Fed has done a lot of heavy lifting in the last 18-months, the real impact has yet to be felt largely because we have not seen a lot of debt maturities.

However, the maturities are coming. Let’s look at a chart that outlines the percentage of high-yield debt that is set to come due:

While interest rates were low for a long time, the period from COVID through YE2021 saw a whole new normal:

If we assume that most of this debt was on average around 5-years, there is going to be some serious sticker shock as we head into 2024/25 and this debt taken out in 2020/21 starts to mature. The average corporate yield from COVID through the end of 2021 was ~2.95%, while the six-month trailing average is ~5.2%, implying an increase of ~$11 million of interest cost per $500 million borrowed. The good news is – this is not as big of an issue for smaller companies (2024 and 2025 are generally light on maturities), the bad news is that smaller companies are more tied to floating rates, so they are already in the proverbial “high interest rate soup”:

What does this mean for the economy? For those that subscribe to the thesis that the recession is coming – the above would be supportive at least as it relates to businesses. The Fed raising rates does not flip a switch in terms of everyone’s debt auto resets, but as more time passes and rates stay at a high level, more and more will be sucked in. For those that subscribe to the thesis that the likelihood of a soft landing is growing – then it’s the consumer side that likely fuels this. Will higher mortgage rates matter? Yes, but largely because of its negative impact on new and existing home sales and not because of its impact on existing borrowers.

What about Canada? Okay, so you knew we were going to get there. Most of what we said above as it relates to consumers is less relevant for Canada. The obvious reason is that Canadians cannot lock in their mortgages for 25-30 years like Americans can.

With most mortgages of the 3-5 year fixed rate variety, Canadian consumers, while bolstered in the same way on the cash flow side by the rise in money market rates, are highly susceptible to mortgage resets in the next few years.

However, overall, the housing market, at least as it relates to activity, probably has a better outlook than the U.S. largely because:

  1. Canadian mortgages can be ported, so owners are not handcuffed to their existing homes.
  2. Immigration remains robust, so the demand side continues to underpin the market, despite the sharp rise in rates.

Thus, in a sense, the Canadian economy is vulnerable to a consumer crisis (unlike the U.S.), but the overall economy should be better positioned than the U.S. as housing is likely to remain stronger.

On the corporate side, the data is skinny for Canada, but there is no reason to believe that it does not resemble the U.S. side – the maturities are coming, and the longer rates remain where they are (or higher), corporations and small businesses are likely to feel the pinch as we get further and further away from that 20/21 sweet spot for borrowing.

Final Thoughts

The past 18-months has seen a shift. Prior to 2022, the power in a sense resided with borrowers as rates were so low for so long (and especially in that 20/21 sweet spot) that borrowers were able to secure funds at historically low rates and with many lenders competing for their business. But with rates now significantly higher and with some of the problems in the U.S. banking system (Silicon Valley Bank, et al), the power dynamic has shifted with lenders now at the fore.

One might ask – but why are bank stocks not doing well? For this, we would cite two reasons:

  1. Repricing takes time: as we noted above, the banks are paying out a lot more on money market funds and the like than they were 18-months ago. However, loans the banks have made have yet to reprice. But this repricing is coming, especially in Canada. So, while the numbers did not look great in 2022 and are not looking great in 2023, a turning point will come.
  2. Credit will be a headwind: while credit losses have generally been fine, with rates significantly higher and mortgages and loans set to reprice, there is likely to be some increase in credit losses over the next 12-18 months. The Canadian banks are generally very good managers of risk, so the increase in losses is unlikely to cause much distress, but it will weigh on earnings to some degree.

Thus, while we continue to believe that a sweet spot for banks is coming, it is likely to be a 2024 event as opposed to 2023.