Interest Rates: Cracks Are Forming In The Economy

For about a year now, the Federal Reserve has been working to combat persistent and painful inflation. This inflation truly was a product of multiple things, the most significant of which was the COVID-19 pandemic. But even though the pandemic is now gone, elevated prices continue to plague the masses. In recent weeks, members of the Federal Reserve came out and suggested that interest rates might need to go up higher than previously anticipated and stay there longer than initially planned in order to get inflation back down to where it needs to be. That caused an initial negative reaction in the market that was then made worse by the collapse of certain financial institutions. Although there’s little doubt in my mind that we will see at least one more interest rate increase in the near term, I am also of the opinion that the most recent developments seen in the market will prove to be a big enough wake-up call for the Federal Reserve for them to quickly change their rhetoric. In fact, I would even go so far as to say that it’s not unlikely that we could see a leveling off of interest rates in the very near term, followed by a potential decline near the end of this year. If this does come to pass, it could prove quite bullish for the market.

A look at rate increases

In response to the COVID-19 pandemic, the Federal Reserve cut interest rates to practically 0%. But with prices on the rise, they began increasing these rates back in March of 2022. The initial change resulted in the Federal Funds Rate range being set at between 0.25% and 0.50%. From that point on, the Federal Reserve began hiking rates rather drastically. The latest increase of 0.25% pushed rates to a range of between 4.50% and 4.75%.

In the early part of 2023, the market began to accept the possibility that we might be near the terminal interest rate. Continued improvements from an inflationary perspective, combined with dovish moves from the Federal Reserve, such as the latest interest rate increase coming in at only 0.25%, had the market thinking that we could achieve the goal of bringing inflation to heal, all without experiencing a hard landing. As a response to this, the S&P 500 reacted bullishly, rising by 9.3% between the start of the year and the end of trading on February 2nd.

Unfortunately, the sentiment there began to change rather rapidly. In particular, on March 7th, the Chairman of the Federal Reserve, Jerome Powell, expressed a willingness to engage in even faster tightening in the event that it is needed. While there are some companies that benefit from higher interest rates, the vast majority of firms do not. Higher rates constrict the ability of consumers to spend, reduce the ability of companies to invest, and they make it more difficult for everybody to borrow. It should come as no surprise then that markets pulled back in response.

We could be near the top

If you take the Federal Reserve at its word, the organization wishes only to go off of what the data says. If this is true, there is now sufficient evidence in my opinion to warrant a topping off of interest rates and, potentially, even a decrease in the not-too-distant future. For starters, let’s look at inflation over the past year. As you can see in the chart below, the year-over-year inflation rate for all items was quite high. It peaked at over 9% back in June of last year. But as interest rates increased, this rate began to fall. This is not to say that it was all driven by higher interest rates. Rather, the likely driver was an improvement in the supply chain, as well as a decline in the price of things like oil. WTI crude, for instance, fell from over $120 per barrel in June of last year to around $90 per barrel three months later. You can actually see that, without factoring in food and energy prices, inflation was not all that high in 2022. And after peaking in September at just under 7%, it began a steady decline until the present day.

Regardless of the role that interest rates had on bringing inflationary pressures down, it is undeniable that they had some impact. And more importantly, it’s clear that the inflation rate is dropping. I already mentioned briefly oil. In general, natural gas has also declined over the past several months. As you can see in the chart below, from March 15th of 2022 to March 15th of this year, natural gas prices plunged from $4.46 per Mcf to $2.49 per Mcf. That’s a drop of 44.2%. Over that same window of time, WTI crude prices declined 29.9% from $96.42 per barrel to $67.61 per barrel. Initially, high prices were driven by a number of factors, including the war between Russia and Ukraine. But now that time has passed, countries have found ways to diversify their energy, with production from the US even rising. From the end of 2021 to the end of 2022, for instance, daily crude oil production in the US managed to increase by roughly 467,000 barrels. For the full year, production from OPEC nations managed to climb from 26.3 million barrels per day to nearly 28.9 million. In fact, according to its own report, OPEC was responsible for producing roughly 430,000 barrels of oil per day more than what the world needed in order to see production and consumption balanced for 2022.

We see other signs that imply that the Federal Reserve might very well be at the point where it can and should level interest rates off. At the end of the day, their goal is not to tank the economy. Rather, it’s to accomplish a soft landing. But there are some industries that are experiencing a tremendous amount of pain at this point in time. One of the best examples of this is the home building space. Given the high price points of homes, as well as the reliance of that industry on loans, it should come as no surprise that this would be a market that would show some of the most severe signs of the toll that interest rate increases can have on the economy.

Using the most recent data available, data that covers January of this year, we can see that the number of permits provided for houses in the US totaled 1.34 million for the month. That’s down from the 1.84 million reported only one year earlier. The number of starts declined during the same time from 1.67 million to 1.31 million. Of course, if you look only at the fundamental data of the home building companies, you wouldn’t see this. A surge in prices charged for their services, combined with the lag between when orders are placed and when they are accomplished, has resulted in a continued rise in the number of properties that are both under construction and that have been completed. In January of this year, 1.70 million homes were under construction, while 1.41 million were completed. These numbers compare to the 1.55 million and 1.25 million, respectively, reported only one year earlier.

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*Data from here, here, here, here, and here.

As part of my analysis, I looked at data covering five of the largest home builders in the country. The results are truly surprising. As you can see in the chart above, the number of units in backlog for each of these five companies has fallen significantly over the past year. The biggest drop came from D.R. Horton, which reported a plunge in backlog of 46.3%, with the number of properties declining from 29,347 to 15,759. And in the chart below, you can see how high the cancellation rate is of new orders compared to what they were one year earlier.

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My goal in this article is not to rehash data that I covered in another article. But the most recent sign that it might be time for the Federal Reserve to become more dovish in its approach involves the multiple banking failures that have hit the US over the past several days. In another article that I wrote specifically on that topic, I discussed how rising interest rates led to a significant decline in funding for earlier-stage companies. The banks that were most exposed to these very companies ultimately saw massive drawdowns of customer deposits as those businesses were forced to utilize their cash balances in order to continue to cover their bills and grow, as opposed to raising capital in this harsh environment. And because most of the accounts involved would not have been guaranteed for most of the funding, the first whiff of trouble at these financial institutions resulted in a classic-style bank run. Continuing to increase interest rates from this point will harm not only these financial institutions more, it will also result in cracks forming in the next weakest part of the economy, whatever that might be. As bad as inflation is, it’s not nearly as bad at current levels or even the levels we saw last year as a financial crisis would be.

Takeaway

Based on the data provided, I do believe that the Federal Reserve is seriously considering a more cautious approach to interest rates moving forward. Although the most recent rhetoric from its members suggested that additional rate hikes might come about and might be here to stay, we are seeing multiple signs that inflation is in the end game. Of course, the Federal Reserve already knows all of the information in this article. None of it so far, with the exception of the development in the banking sector, would have likely been enough for them to change their tune. But I do believe the deterioration in the financial sector could serve as that final straw. This is not to say that I don’t expect a rate increase in the coming days. I would be surprised if they don’t raise rates by 0.25%. But in all likelihood, they will take this opportunity to establish that further rate increases might not be needed or would be modest and would last for a shorter time than what many might fear.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.