REAL ECONOMY BLOG | April 22, 2024


Higher-for-longer now applies to more than just the federal funds policy rate. It means a regime change for companies of all sizes when it comes to the cost of financing expansion or funding their operations.

Higher-for-longer now applies more than just the federal funds rate. It applies to the cost of doing business.

Whether it be high single-digit borrowing costs for large multinationals or double-digit financing costs for middle market firms, elevated interest rates have become a fact of life for firm managers, and policymakers.

While much as been written about central bank policy rates, not enough has been written about the rising cost of doing business in the post-pandemic era.

Here we take a look at nominal and real financing costs and offer a primer on how interest rates are determined.

Nominal borrowing rates

The global increase in the cost of corporate debt appears to have peaked late last year, with rates in this latest cycle settling into trading ranges formed over the last year and a half.

For American corporations issuing investment-grade debt, that increase means debt service as high as 6.6% per year to as low as 5.5%, while averaging about 5.9%.

Corporate five-year borrowing rates in Canada occupied the lower part of that range, with rates averaging 5.1% during that period. In the U.K., five-year borrowing costs are averaging 5.5%.

With the European Central Bank’s overnight rate a full percentage point below the federal funds rate, the cost of five-year corporate borrowing in the Euro area has been 3.3% to 4.3%, while averaging 3.9%.

These ranges seem likely to hold should the recovery continue and the commodity markets withstand further geopolitical disruptions.

We can at the same time expect nominal rates to move lower in those ranges once it becomes clear that central banks can begin to cut their policy rates.

Corporate borrowing rates nominal terms

Real borrowing rates

But a reduction in policy rates does not necessarily mean that the real, or inflation-adjusted, cost of borrowing will also decline.

Instead, if inflation were to continue to drop while borrowing rates remain sticky, real interest rates would remain elevated or even increase. Real corporate borrowing rates stand at 2.6% in the U.S., 2.2% in the UK, 1.3% in the European Union and 2.0% in Canada.

In addition, the added real cost of servicing debt while inflation recedes will add urgency to what we will think will be a multiyear rate-cutting cycle by global central banks.

That’s not to say we should not welcome the transition from tight monetary policy to a more accommodative stance.

Instead, corporations have no choice but to accept that the cost of borrowing is increasing in both nominal and real terms. The way out of this squeeze, then, is increased economic growth, which can support higher costs in the labor market and in financing.

But there is only so much that central banks can do to influence growth. We saw that in the aftermath of the Great Recession, in which growth was sluggish for years even as central banks held interest rates near zero or in some cases imposed negative interest rates.

That is why developed markets are investing in infrastructure and embracing industrial policy.

To paraphrase John Maynard Keynes, there are times when fiscal policy becomes the only choice for supporting economic growth.

This seems the right time to support higher-end economic activity that will increase corporate profits, household incomes and tax revenues.

To better understand these dynamics, consider the recent developments in the bond market and the determination of interest rates.

Corporate rates in real terms

Short-term trading

The market has reacted to inflation’s sluggish downtrend by pushing bond yields and market volatility back to their highest points since last year.

In mid-April, both the Treasury and corporate bond markets pushed interest rates above their narrow 50-basis point trading ranges established since the middle of last November.

Apart from a few short dips, 10-year Treasury bonds had been trading within a 4.0% to 4.5% range while investment-grade corporate bonds traded 150 basis points higher within a 5.5% to 6.0% range.

Within those ranges, yields have been trending higher as the market has come to terms with the strong labor market, stubborn inflation and the Federal Reserve’s reluctance to cut its policy rate.

Only when Federal Reserve Chairman Jerome Powell spelled out that reluctance did traders to push 10-year Treasury yields to nearly 4.7% on April 16 before closing the week at 4.6%.

Treasury vs. corporate rates

The end of low-for-long rates

Looking at only the past 12 months of Treasury bond trading shows a flat range. But when looked in a longer time frame, a more dramatic picture of the changing landscape for borrowing and lending emerges.

From 2000 until the 2020 pandemic, interest rates were in decline as the global economy slept through the transition from abundant external supply and disinflation to the current state of insufficient aggregate supply and inflation.

The cost of corporate debt dropped from 9% in 2000 to 4% before the pandemic shutdown. The yield on 10-year Treasury bonds dropped from more than 6% in 2000 to 1%, with little room to go.

Since then, the inflation shock occurring on top of the normal recovery from an economic crisis has doubled the cost of corporate debt from 3% to 6%, with 10-year Treasury yields increasing from less than1% to 4.25%.

It’s hard to imagine any reason for interest rates to drop that much lower, however. Outside of a collapse in the global economy, fiscal policies put in place to promote friend-shoring and advanced industry should provide a backstop to economic activity.

Treasury vs. corporate yields since 2000

Interest rate primer, Step 1: Everything starts with r-star

We need to begin with the natural rate of interest, which is the real interest rate consistent with the economy operating at its potential and with stable inflation. The natural rate is referred to as r* or r-star.

According to research by the economists Thomas Laubach and John C. Williams of the Board of Governors of the Federal Reserve System, economic theory implies that the natural rate of interest varies over time and depends on the trend growth rate of output.

We can think of the natural rate of interest as the minimum rate of return that investors would require before putting their cash on the line, assuming price stability.

The level of the natural rate is transmitted to the economy through the Federal Reserve’s policy rate. Assuming that the economy is operating at full employment and that prices are stable, the nominal value of the federal funds rate would be equal to the natural rate plus the inflation rate.

At the time of the economist John Taylor’s research in the 1990s, the natural rate could be thought of as being 2%, which when added to the normal 2% inflation would result in a nominal federal funds rate of 4%.

Nominal fed funds rate

As estimates by Laubach, Williams and, later, Kathryn Holston show, the natural rate of interest dropped from 5% to 3% after the 1960s peak of postwar industrialization, and then drifted sideways and down to 2.5% as the economy and the labor market transitioned from manufacturing to services.

There was an uptrend in the 1990s that accompanied the rapid spread of personal computing. But that was followed by the downturn in 2000 and then the disastrous impact of the financial crisis. During that downturn, the last remnants of manufacturing and investment were shipped offshore to low-cost centers.

The economy stopped investing in itself, the fiscal authorities refused to respond, and the normal levels of growth were replaced by economic stagnation, near-zero interest rates, deflation exported from Asia, and a surplus of cash. All that helped send the natural rate of interest to 1%.

Natural rate of interest vs. growth

Step 2: Expectations of monetary policy and event risk

The next step in determining nominal interest rates involves the market’s best guess on the direction of Federal Reserve policy and the risk of issuing or holding a security.

Because the Fed must react to shocks by either raising or lowering the federal funds rate, investors will require compensation for the possibility that an event knocks the Fed off of its policy path. The tariffs of 2019 and the inflation shock of 2022 are the latest examples of such an event.

This event risk is referred to as the term premium in the case of Treasury bonds. The term premium will be positive under normal conditions to compensate investors for holding a security to its maturity. It will be negative if there is a perceived risk of an economic collapse and deflation.

In the case of corporate bonds, this risk premium will also include the risk of default, referred to as credit risk. For investment-grade corporate bonds in recent times, credit risk has added roughly 1.5% onto the guaranteed interest rate of a 10-year Treasury bond.

Short and long-term nominal interest rates

Step 3: Estimating the real cost of investment

The cost of investment is the interest rate on the loan or the yield of the bond. The cost of servicing borrowing, however, will be determined by changes in the value of money over the life of the loan or the maturity of the bond.

Under normal circumstances of, say, 2% inflation, the fixed cost of servicing a loan will be deflated by 2% per year because of the diminished purchasing power of the dollar.

During periods of deflation like the sluggish 2010-19 recovery, the fixed cost of a loan would have increased because of the foregone purchasing power of each dollar.

Our rule of thumb is to estimate the real rate of interest as equal to the nominal interest rate minus the consumer price index.

But that is just a rule of thumb; using inflation expectations over the life of the bond is perhaps more appropriate.

Estimating real interest rates

The takeaway

We are into the second year of what we think is a long-term regime change in global financial markets. This change is characterized by insufficient aggregate supply, the re-shaping of supply chains, and geopolitical tensions.

As a result, the emerging economic framework will feature higher long-terrn natural rates of interest, elevated policy rates compared with the 2000-2020 period, and higher inflation.

For businesses, the means that their cost of operating has permanently changed. Now, firms need to choose expansion projects more carefully, be more selective in acquiring talent, and emphasize efficiency in a way that before was not required.

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This article was written by Joseph Brusuelas and originally appeared on 2024-04-22.
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