Central bank interest rate rises are always associated with an increase in the cost of debt, which has led to yields on 10-year government bonds rising from 0.5% to 4.4%. This is, after all, the main objective of this monetary policy tool, to cool the economy (and indirectly inflation). However, let us take a closer look at the debt situation of consumers and companies to answer the question: are we facing a repeat of the 2008 crisis and how might the current situation affect financial markets?
Situation in the banking sector
To start with some worrying data, the level of commercial bank lending to the central bank (the Fed), which in March this year exceeded half of that of the 2008 banking crisis. Such loans are made when banks (as depository institutions) are having trouble paying out deposits, due to the so-called fractional reserve system by which banks are not required to hold all of their customers' money. Currently, the mandatory deposit level in the United States is 5.4%. The loan support was linked to the problems of the banking sector at the beginning of the year, but the sheer scale of the support may be surprising. Indeed, it was 6 times larger than that during the pandemic crisis.
Source: Fred
We could issue a second yellow card in the context of the decline in asset levels in the banking sector. This decline is mainly due to a reduction in lending activity, meaning that banks are finding it harder to make new loans, partly because of the current economic uncertainty. A similar situation occurred during the 2008 crisis. However, it is important to emphasise that this happened in combination with a high percentage of outstanding loans (over 30 days). Today, it remains at historically low levels, at just 1.22%, compared to 7.5% at the height of the financial crisis. Of course, these figures are aggregate, so let's look at them in more detail for more information.
Source: Fred
Rising cost of consumer credit
If we look at lending rates by type of loan, we can immediately see a departure from the norm. Particularly pronounced seems to be the sharp increase in interest rates on credit cards (Commercial Bank Interest on Credit Cards Plans) to 20.6%, compared to 13.3% during the financial crisis in 2008. The high lending rates cannot be clearly explained by the difference in interest rate levels, as the interest rate levels of 2008 were practically no different from today. This situation may appear to be particularly worrying and the consequence may be a fall in real household incomes and a decrease in demand for new debt, resulting in lower consumer spending. This could have a negative effect on sales in the consumer goods sector in the medium term, and would also negatively affect the listing of the Consumer Discretionary Select Sector SPDR Fund (XLY).
Source: Fred
Source: Conotoxia MT5, XLY, Daliy
If we look at the level of household indebtedness relative to the previous crisis, we see that the level of indebtedness through consumer credit liabilities and car credit has increased particularly strongly. Despite an increase in interest rates for all types of credit, we do not see a decrease concerning their demand, which should translate into a decrease in disposable income in the future. However, we can note that the total level of debt relative to income has now fallen from 120%. - during the crisis in 2008 to 89%. - now, which means that consumers are less indebted now than they were during the crisis.
Source: Fred
We often hear about declining household savings as a potential trigger for the crisis. Indeed, at present, if we look at household savings levels, we see a decline after the sharp increase in 2020 that resulted from government welfare programmes. The level has fallen from 25% to the current 4.5%. Even though we are currently at similar levels, debt servicing expenses do not seem to be as burdensome as they were in the past. It is worth understanding that the majority of mortgages are at a fixed rate for the life of the loan. This means that only those loans taken out now will materially affect available income in the future.
Source: Fred
What lies ahead?
According to the CME FedWatch tool, which measures the market's valuation of the probability of interest rate changes by the Fed, we will learn that the market is now largely assuming a halt to the interest rate hike cycle and the first cuts next June. Which assets are likely to be most affected by this period?
The first asset, which is itself a type of given debt, is bonds. In the absence of a change or drop in interest rates, we have historically seen bond funds rise in the market, currently trading at 12-year lows. An example of such a fund would be the iShares 20 Plus Year Treasury Bond ETF (TLT).
Source: Contoxia MT5, TLT, Daily
When interest rates fall, profit margins in the financial sector tend to fall. The main way for banks to make money is through interest on borrowed money. When a bank lends money at a low interest rate (caused by a fall in interest rates), this results in a fall in the institution's profit, which could negatively affect the Financial Select Sector SPDR Fund (XLF) listing.
Grzegorz Dróżdż, CAI MPW, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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