Stocks are becoming more sensitive to interest-rate hikes because the global economy is overleveraged.
The U.S. stock market took a 10-day up-and-down ride after the Federal Reserve announced a quarter-point increase in the target for the federal-funds rate just before Christmas. The Dow Jones Industrial Average lost more than 2,300 points—10% of its value—in the six trading days from Dec. 17-24, before regaining nearly 1,100 points on Dec. 26. Other stock-market indexes traced similar patterns.
Though extreme, the selloff was in step with the going trend. In recent years financial markets have thrown a temper tantrum every time the Fed has even hinted at an interest-rate increase. The markets also dropped after quarter-point rate hikes in March, June and September 2018 before stabilizing somewhat at year’s end.
The jumpy market reaction to rising interest is a recent development, and a mysterious one. It was common through most of the postwar period for the Fed to increase interest rates during economic expansions without setting off explosions in the stock markets. That’s exactly what central banks are expected to do: raise rates gradually as unemployment falls and gross domestic product expands. Between February 1994 and 1995, for example, the Fed nearly doubled the fed-funds rate from 3.25% to 6%, yet stocks moved steadily upward. The market was similarly undisturbed between June 2004 and 2006, when the Fed raised its target interest rate from 1% to 5.25%. Unlike today, investors seemed to take the increases as signs that the overall economy was likely to expand further.
Fed Chairman Jerome Powell maintains that gradual rate increases are appropriate given the health of the U.S. economy and the historically low unemployment rate. The Fed governors have also set a goal to restore interest rates to normal levels after keeping them close to zero for a decade following the financial crisis. Yet after the market meltdown in December, Mr. Powell announced that the Fed would pause or moderate its rate increases in 2019, which the markets took as reassuring news.
Wall Street analysts and business leaders have struggled to explain the market’s anxious aversion to normal Fed policy. Some suggest that the stock market is signaling a recession in 2019, while others point to President Trump’s trade policies as a cause of market instability. Many note that higher rates will make bonds more attractive compared with stocks.
Any or all of these factors may have played a role in the selloffs, but they can’t explain the immediate rallies that usually follow. Financial markets have become specifically sensitive to interest-rate increases, no matter how trivial they seem from a historical perspective.
A different, slow-developing trend helps explain market sensitivity today: the mountain of debt that has accumulated world-wide, and particularly in the U.S. Global credit-market debt, which includes all government, corporate and consumer debt, reached $244 trillion in 2018, compared with world-wide economic output of $85 trillion—a ratio of nearly 3 to 1. The situation is worse in the U.S. The St. Louis Fed calculates that total U.S. credit-market debt was $69 trillion at the end of 2017, compared with $19.4 trillion of GDP—a ratio of 3.6 to 1.
Debt has accelerated in the U.S. and abroad for more than three decades, partly as a consequence of historically low real interest rates. (Another factor is declining inflation, along with financial innovations like asset-backed securities, which make it easier to issue and carry debt.) From 1950-80 the ratio of U.S. credit-market debt to GDP hovered around 1.5, but from there it has risen somewhat steadily—to 2.4 in 1990, 2.9 in 2000 and 3.7 in 2010, falling a bit to 3.6 today. Credit-market debt has risen 15-fold since 1980, compared with a sevenfold increase in nominal GDP.
Most debt hawks rightly focus on the size of the federal debt—currently $21.5 trillion—because interest payments take up a rising share of federal spending. The U.S. government spent $315 billion in net interest payments last year, nearly 8% of its total $4 trillion in expenditures. Though the average annual interest rate on federal debt has fallen, from 6.6% in 2001 to 2.5% today, the drop in per-dollar interest has encouraged the government to borrow much more. Now a return to a normal rate of 6% or 7% might double or even triple annual interest payments, crowding out other spending.
Even still, federal debt makes up less than a third of total U.S. debt. The rest comes from financial institutions ($16 trillion), mortgages ($15.4 trillion), nonfinancial corporations ($9.5 trillion), consumer credit instruments ($3.9 trillion) and state and local governments ($3.1 trillion, not including pension obligations). Since 2010, corporations have taken advantage of low real interest rates to increase borrowing by 50%, from $6 trillion in 2010 to more than $9 trillion last year. This debt pile surely accounts for part of Wall Street investors’ sensitivity to rising interest.
It’s true that all these debts correspond with countervailing credits on other balance sheets in the U.S. and abroad. Moreover, much of the debt is backed by assets that can be sold to pay it off. Yet overall, rising interest costs put pressure on corporations and households to reduce investment and consumption. Taken too far, rising rates could lead to defaults and asset sales and, in turn, to a downward spiral in asset prices—a cycle no one wants to return so soon.
The Fed is walking a fine line, trying to encourage borrowing through low rates while also committing to normalize rates ahead of eventual inflation. Judging by recent market reactions, it doesn’t have much room to maneuver. This means its announced goal of returning to historically normal rates may not be wise under current debt conditions.
This piece originally appeared at The Wall Street Journal
______________________
James Piereson is a senior fellow at the Manhattan Institute.
This piece originally appeared in The Wall Street Journal