Sharply Climbing Rates Hit Banks, Here’s What Else Is At Risk

The Federal Reserve has increased interest rates at a historically high pace to control inflation but the side effects of that policy have contributed to banking failures. It’s also likely that higher interest rates will be felt by the housing market, perhaps cause a recession and even impact the federal budget if sustained over the coming months and years.

Rising Rates

The Federal Funds rate has risen from effectively zero at the start of 2022, to more than 4.5% today. That’s an abrupt change in interest rates over a period of little more than a year. It’s pressured banks as the assets they typically hold such as government debt and other fixed income assets have fallen sharply in value as rates rose. That’s contributed to the collapse of Silicon Valley Bank and Signature Bank and also created pressures at First Republic Bank FRC and internationally at Credit Suisse. The good news is markets think that we may be getting close to the top of the interest rate cycle. Still, this sharp change in yields has pressured the financial system and there may be more to come beyond the banking sector. There may also be more to come in the banking sector with U.S. regional bank stocks selling over 25% for the year so far. That’s partially a reflection of existing failures, but also signals the markets’ diminished confidence in the banking sector as a whole.

Declining Home Prices

Rising rates typically work through home prices. We haven’t seen annual declines in home prices yet, but those could be coming. That’s because what most buyers can afford is determined not by the absolute cost of their homes but the monthly cost of their mortgages.

Rising interest rates have caused mortgage rates to rise. A 30-year mortgage rate has roughly doubled off recent lows from 3% to 6%. That’s caused a major decline in housing affordability. Given that for many households’ largest assets are their homes, declining home values could have a broad impact on consumers. On most estimates home prices have been falling back from peak levels last summer, but we haven’t seen year-on-year declines in most home price measurements yet. That could be coming over the next few months. Home building is also a large swing factor in economic growth, and disruption there could elevate recession risk. There are also fears for the commercial real estate sector too, in part because office occupancy remains low as remote work is still a fixture of many white-collar industries.

Recession

Despite the banking crisis, we have not yet seen a recession. In fact, the U.S. economy has defied expectations over recent months, with the jobs market in particular remaining robust as growth in service industries more than offsets layoffs in certain sectors such as tech.

However, the Fed has started to hint that it may take a recession to get inflation in the U.S. fully under control and the recent banking crisis won’t help economic growth. The yield curve, which has historically been accurate at predicting recessions gives a strong signal that one could be near.

The Federal Budget

Interest rates remaining at high levels will start to eat into the federal budget. The U.S. government has taken on increasing debt over recent years due to the Covid-19 pandemic response and other initiatives. However, the increase in debt corresponded with a period of extremely low interest rates, so the cost of servicing the debt did not rise in proportion to the level of debt.

With rising interest rates that’s changing. In 2022, interest expense was 8% of the federal budget, but that could be set to almost double in the coming decade if interest rates remain high. That could cause issues for other spending priorities. Much of this depends how longer-term interest rates trend: Currently the markets expect that interest rates may ultimately fall from here, but incremental pressure on the federal budget from higher interest rates seems probable. This also feeds into the debt ceiling debate, which is another risk for markets regardless of interest rates.

Rising interest rates stress an economy in multiple ways. This is expected as that’s, in part, how these indicators are expected to work in helping moderate inflation and interest rates are a blunt instrument. However, high rates have also been a catalyst for the recent banking crisis and we could see subsequent issues for the housing market, a broader recession and even government debt if rates stay at elevated levels after the recent sharp increase.

The relatively good news is that markets believe we are getting close to peak interest rates, and the Fed may be prompted to actually cut rates, providing an incremental boost to the economy if major issues do surface. Still rising rates could stress the broader U.S. economy in other ways beyond the banking failures we’ve already seen.