We may be getting close to “the end” of the Federal Reserve’s (“Fed”) interest rate hiking cycle. This week, the Fed increased the Funds Rate 75-basis points (a basis point equals 1/100th of 1%, or 0.01%). The Fed has increased rates 3.00% since March of this year from a range of 0.00% to 0.25% to 3.0% to 3.25%. But when will the Fed stop raising rates or reach the so called “Terminal Rate”. There’s been quite a bit of talk about the “Terminal Rate”, but what exactly is it and why should you care.
According to Market Watch, the Terminal Rate is “the peak spot where the benchmark interest rate — the federal funds rate — will come to rest before the central bank begins trimming it back.” The key questions going forward are 1) how quickly Fed will get to there, and 2) how long they will stay there.
Based on the Fed’s Summary of Economic Projections, the Fed “expects” interest rates to reach 4.40% by the end of 2022 and 4.60% in 2023, before declining to 3.9% in 2024. This suggests 4.6% is the terminal rate and it will be reached early next year. So, we can expect interest rates to increase an additional 1.0% to 1.25% this year and 25 to 50-basis points next year.
Such a rapid increase in interest rates could mean more bad news for Stock. Given stock prices are based on expectations of future cash flows, discounted to present value, rising interest rates mean rising discount rates, which means lower valuations. Also, as interest rates increase, company’s operating costs tend to increase, which could also negatively impact earnings. So, equity markets could be hit with a double whammy, lower earnings and higher discount rates.
Rising rates also mean trouble for the housing market. As interest rates increase the cost of financing a home purchase increases. The increases mean potential home buyers will either need to 1) buy a lower cost home, or 2) delay their home purchase and rent. Unfortunately, US housing inventory remains low, and demand for housing remains high, so rental rates are at al- time highs. In a recent interview with The Atlantic, Jeff Tucker, a senior economist at Zillow said their annual index of rent growth hit a record-high 17 percent.
Finally, the Fed expect the target Terminal Rate to increase the unemployment from 3.7% to 4.4%, a significant move which is likely to result in a recession.
For Small Business Owners, now is a good time to take a close look at your balance sheet. Do you have sufficient capital to survive a recession, shallow or deep. Do you have any floating rate debt? How will your cash flow be impacted by a 1.25% rate increase?
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