4 Risks Fed Rate Cuts Could Help


The Fed’s rate hike cycle heightened (at least) 4 different risks to the economy. With the Fed pivoting to cutting rates, here’s how those risks should lessen.

1. Small companies rely more on floating rate debt, so higher rates crimped margins

Higher rates especially squeezed margins for small companies – whether small businesses or (listed) small caps. That’s because half of small business debt and nearly 40% of small cap debt is floating rate, compared to just 7% for large caps.

With the Fed’s rate hike cycle nearly doubling short-term borrowing rates for small companies to 9.5%, the ratio of interest costs to earnings also doubled for small caps to over 40% (chart below, green line). Apart from an earnings slump-driven spike during Covid, that’s the highest ratio going back at least to the mid-90s.

By comparison, mid caps (grey line) and large caps (black line), which locked in more low fixed-rate debt early in the pandemic, have seen much smaller increases in interest costs.

Shrinking margins had knock-on effects for the economy. They contributed to the earnings recession small caps have seen for two years now, and the cooling labor market.

That’s because small businesses responded to higher rates by reducing their hiring plans to around their lowest levels since 2016, which had a significant impact since small businesses account for nearly half of all employment in the US.

So, if we get a soft landing as rates come down, that should help margins at small companies – potentially boosting earnings and the labor market.

2. Higher rates reduced housing demand and supply

Of course, it’s not just businesses that faced higher borrowing costs.

The Fed’s rate hike cycle pushed up rates on 30-year mortgages from about 3% in early 2022 to nearly 8% last year. This dramatically slowed the housing market, reducing both demand for home buying (which fell 40%) and the supply of homes for sale (since people with a low mortgage rate didn’t want to reset to a much higher rate).

But as markets increasingly priced in Fed rate cuts, we’ve seen 30-year mortgage rates fall from 8% to almost 6% now (chart below, blue line). Already, that’s led to refinancing nearly tripling from its late 2023 lows (red line).

And now housing demand has also started to pick up. Last week, mortgage applications rose year-over-year for the first time in over 3 years. If home buying rises further, that would help reduce rental demand, which would take pressure of rents – the biggest source of excess inflation currently.

But with 75% of outstanding mortgages at rates under 5%, it will still take a while for the housing market to normalize.

3. Inverted yield curve squeezed bank margins and higher rates drove $700bn in unrealized losses

Rising mortgage demand could also help bank balance sheets, which were a source of stress that contributed to the 2023 banking crisis.

In short, banking relies on “borrowing short” (paying depositors a rate loosely tied to the fed funds rate) and “lending long” (charging a higher long-term rate on loans). This spread is squeezed when the yield curve is “inverted” (short rates higher than long rates) as it’s been for the last couple years.

But, with the Fed cutting rates, short rates have fallen faster than long rates, un-inverting the yield curve. So that makes it easier for banks to charge 6% on a mortgage, but pay even lower rates on deposits, expanding their margins.

Lower rates also help another problem for banks: unrealized losses.

This goes back to the start of the pandemic. When Covid stimulus went out to businesses and households, deposits at banks rose. Since people were flush with cash, loan growth slowed, so banks bought securities (at low rates) in 2020 and 2021 to earn some yield on the excess cash.

Once the Fed pivoted to hiking rates in 2022, however, yields rose (chart below, red line), reducing the value of banks’ securities (bars), creating unrealized losses of nearly $700 billion.

As yields have fallen in anticipation of Fed rate cuts, those unrealized losses have dropped to about $500 billion, and could fall further if yields decline more. That, plus a wider spread between short and long rates, would take some stress off banks.

4. Higher rates made Commercial Real Estate refinancing harder

Like banks, commercial real estate has faced multiple challenges in recent years, and lower rates could help there too.

CRE loans are typically interest-only, followed by a balloon payment for the value of the loan at the end. One reason CRE loans are often refinanced is to avoid that balloon payment.

With rates being so much higher than they were a few years ago, refinancing has been harder to do (fewer buildings generate enough income to cover payments).

So lower rates make it possible to refinance a bigger share of CRE debt (and there’s $1.5 trillion in debt that needs to be refinanced by the end of 2025, according to BofA).

Lower rates alone won’t solve the structural problems facing offices, however. The rise of remote/hybrid work has office values down nearly 40% from their peak, leaving some building owners with no choice but to default on their loans.

Lowering rates reduces the risk something “breaks”

When the Fed is hiking rates, the concern is they won’t stop until something “breaks.”

These 4 areas were some of the top contenders for things that could break. So far, it looks like we’ve avoided that (the relatively contained 2023 banking crisis aside).

And with rates coming down, the hope is nothing (else) breaks.

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