7 ms·

Can you go one level deeper- why would raising interest rates trigger a recession?

silexia 5y ago
The US government and corporations borrow money at the prime interest rate plus some margin. Right now, US corporations have borrowed the maximum they possibly can. If the interest rates on that debt go up, many corporations will immediately go bankrupt. The US government also has a debt ceiling it is refusing to raise, which may mean that the US government itself may become insolvent faster with an increase in interest rates.
- whimsicalism 5y ago
  > If the interest rates on that debt go up, many corporations will immediately go bankrupt Do you know which rates are the ones the Fed sets? These threads always bring out the people who don't understand how the economy works.
  - silexia 5y ago
    Ah fun, a baseless ad hominem attack. The feds sets the prime rate which then works its way down into the corporate markets. Corporations right now are borrowing at 1 or 2% interest rates, but if the fed rate goes to 5% then those corporations will have to roll over their existing debt at 5 or 6%. BTW, I majored in finance in college and worked at Merrill Lynch. 12 years ago I started my own company and have 200 full-time employees. I think I know a little bit about how the economy works.
    - whimsicalism 5y ago
      > BTW, I majored in finance in college and worked at Merrill Lynch As an intern, yes? I know enough people working sell-side to know that it doesn't give you an intimate understanding of the economy, and certainly not after an internship. > Corporations right now are borrowing at 1 or 2% interest rates, but if the fed rate goes to 5% then those corporations will have to roll over their existing debt at 5 or 6%. Fair enough. I don't think we will be seeing 5% anytime soon, nor do I think that will be necessary for a price level increase largely driven by disruption to real output due to the pandemic.
    - opo 5y ago
      >The feds sets the prime rate... Just to clarify, the Fed doesn't directly set the prime rate, though it does have influence on it: >...Although the Federal Reserve has no direct role in setting the prime rate, many banks choose to set their prime rates based partly on the target level of the federal funds rate--the rate that banks charge each other for short-term loans--established by the Federal Open Market Committee. https://www.federalreserve.gov/faqs/credit_12846.htm https://www.federalreserve.gov/faqs/credit_12846.htm
    - dragonwriter 5y ago
      > The feds sets the prime rate No. The Fed sets the target for the Federal Funds Rate (currently, as a range target, used to be a single rate target), which is an interbank lending rate, but don't actually set that actual rate (but it is usually very close to or within the target range.) Currently, the actual Fed Funds Rate is 0.25%, the target range is 0-0.25. The prime rate, a measure of available commercial rates, is set by banks lending decisions. It is pretty invariably higher than the Fed Funds Rate; currently, its 3.25%. > if the fed rate goes to 5% ...it would be an enormous jump from the lowest its ever been to the highest since before the 2009 crisis.
      - silexia 5y ago
        You are correct on all points. I know the Fed sets the targets and can't always get what they want, but effectively in recent past they have set the general direction of these rates. I was trying to oversimplify.
- ac29 5y ago
  > If the interest rates on that debt go up, many corporations will immediately go bankrupt. Interest rates on 10 year debt have gone up about 0.75% in the past year or so already (based on US 10 year treasuries, a common benchmark). They currently are at about 1.5%, a little below the average for the past decade of around 2%. I'm curious which companies, specifically, you think will "immediately" go bankrupt if interest rates come back up to 2% - a rate they were paying as recently as 2 years ago.
cj 5y ago
I don’t fully understand why, but in general stocks tend to fall when interest rates rise. Investopedia chalks much of it up to psychology and… higher rates means less lending means less spending means less earnings. https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/#impact-of-expectations https://www.investopedia.com/investing/how-interest-rates-af...
- whimsicalism 5y ago
  > stocks tend to fall when interest rates rise. unexpectedly* stocks tend to fall when interest rates rise unexpectedly. many actual interest rate increases are followed by stocks rallying because a larger rate increase was expected & priced in.
  - dragonwriter 5y ago
    > many actual interest rate increases are followed by stocks rallying because a larger rate increase was expected & priced in. Right, but that just means more than 100% of the fall due to the rate increase occurred earlier when it was anticipated, so the rate increase still caused the fall, in effect.
    - whimsicalism 5y ago
      The expectation caused the fall. It's possible to even have an expectation of a rate increase and then not have any at all.
- deleted 5y ago
  [deleted]
- jliptzin 5y ago
  Look at the formula for discounted cash flow. It's a widely used valuation model and applies to lots of companies, especially those in the growth phase where current market cap is largely dependent on expected cash flow far into the future. https://en.wikipedia.org/wiki/Discounted_cash_flow https://en.wikipedia.org/wiki/Discounted_cash_flow Notice the denominator in the series - (1+r)^n where r = interest rates and n = number of years out. The more r rises, the more terms at the end of the series drop out because they're so close to zero. So that effectively means a company that's getting its value from cash flow 10+ years from now loses a lot of its value if interest rates are rising.
murgindrag 5y ago
Imagine you're a business with 5 million dollars in revolving debt, at a 2% interest rate. You have $100k in debt service costs. If interest rates go up to 5%, you have $250k in service costs. Most businesses operate close to break-even (in efficient markets), and many will immediately go under. If businesses go under, that triggers a recession cycle: Those businesses lay off employees, who stop buying, driving down revenue for everyone else. People anticipating layoffs/furloughs/etc. stop buying. Hiring goes down too, since businesses start planning for rough times. People buying on credit (anyone with a credit card debt) also find purchasing much more expensive, together with higher bills on existing debt. A whole bunch of business opportunities also disappear in a poof of smoke. If a business has even a 1% expected real return, and interest rates are zero, it makes sense to borrow money to start that business (especially if inflation is also high, giving effective negative interest rates). If a business has an expected 1% return and interest rates are 12%, then I'm bleeding money. For these kinds of opportunities, think less SV startup, and more just normal businesses (e.g. I buy something and sell it a month or two later). All of this piles on to form a recession.
- hammock 5y ago
  So commercial debt is mostly variable not fixed rate?
  - Ekaros 5y ago
    My understanding bonds are mostly fixed rate. Their price on market can vary though. But unlike let's say mortages they are more often refinanced. And when that happens the rates can change.
- cannabis_sam 5y ago
  > Most businesses operate close to break-even (in efficient markets), and many will immediately go under. Then they are not managing risk properly and actually need to go under.
  - ac29 5y ago
    I'm not even sure that its true to a meaningful degree - at least in the US, large businesses dominate economically and are quite profitable (much better than "break even"). Microsoft, Berkshire Hathaway, JP Morgan - they are not going to "go under" if interest rates go up 0.25%, even though they all use corporate debt.

The US government and corporations borrow money at the prime interest rate plus some margin. Right now, US corporations have borrowed the maximum they possibly can. If the interest rates on that debt go up, many corporations will immediately go bankrupt. The US government also has a debt ceiling it is refusing to raise, which may mean that the US government itself may become insolvent faster with an increase in interest rates.

whimsicalism 5y ago
> If the interest rates on that debt go up, many corporations will immediately go bankrupt Do you know which rates are the ones the Fed sets? These threads always bring out the people who don't understand how the economy works.
- silexia 5y ago
  Ah fun, a baseless ad hominem attack. The feds sets the prime rate which then works its way down into the corporate markets. Corporations right now are borrowing at 1 or 2% interest rates, but if the fed rate goes to 5% then those corporations will have to roll over their existing debt at 5 or 6%. BTW, I majored in finance in college and worked at Merrill Lynch. 12 years ago I started my own company and have 200 full-time employees. I think I know a little bit about how the economy works.
  - whimsicalism 5y ago
    > BTW, I majored in finance in college and worked at Merrill Lynch As an intern, yes? I know enough people working sell-side to know that it doesn't give you an intimate understanding of the economy, and certainly not after an internship. > Corporations right now are borrowing at 1 or 2% interest rates, but if the fed rate goes to 5% then those corporations will have to roll over their existing debt at 5 or 6%. Fair enough. I don't think we will be seeing 5% anytime soon, nor do I think that will be necessary for a price level increase largely driven by disruption to real output due to the pandemic.
  - opo 5y ago
    >The feds sets the prime rate... Just to clarify, the Fed doesn't directly set the prime rate, though it does have influence on it: >...Although the Federal Reserve has no direct role in setting the prime rate, many banks choose to set their prime rates based partly on the target level of the federal funds rate--the rate that banks charge each other for short-term loans--established by the Federal Open Market Committee. https://www.federalreserve.gov/faqs/credit_12846.htm https://www.federalreserve.gov/faqs/credit_12846.htm
  - dragonwriter 5y ago
    > The feds sets the prime rate No. The Fed sets the target for the Federal Funds Rate (currently, as a range target, used to be a single rate target), which is an interbank lending rate, but don't actually set that actual rate (but it is usually very close to or within the target range.) Currently, the actual Fed Funds Rate is 0.25%, the target range is 0-0.25. The prime rate, a measure of available commercial rates, is set by banks lending decisions. It is pretty invariably higher than the Fed Funds Rate; currently, its 3.25%. > if the fed rate goes to 5% ...it would be an enormous jump from the lowest its ever been to the highest since before the 2009 crisis.
    - silexia 5y ago
      You are correct on all points. I know the Fed sets the targets and can't always get what they want, but effectively in recent past they have set the general direction of these rates. I was trying to oversimplify.
ac29 5y ago
> If the interest rates on that debt go up, many corporations will immediately go bankrupt. Interest rates on 10 year debt have gone up about 0.75% in the past year or so already (based on US 10 year treasuries, a common benchmark). They currently are at about 1.5%, a little below the average for the past decade of around 2%. I'm curious which companies, specifically, you think will "immediately" go bankrupt if interest rates come back up to 2% - a rate they were paying as recently as 2 years ago.

cj 5y ago

I don’t fully understand why, but in general stocks tend to fall when interest rates rise. Investopedia chalks much of it up to psychology and… higher rates means less lending means less spending means less earnings. https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/#impact-of-expectations https://www.investopedia.com/investing/how-interest-rates-af...

whimsicalism 5y ago
> stocks tend to fall when interest rates rise. unexpectedly* stocks tend to fall when interest rates rise unexpectedly. many actual interest rate increases are followed by stocks rallying because a larger rate increase was expected & priced in.
- dragonwriter 5y ago
  > many actual interest rate increases are followed by stocks rallying because a larger rate increase was expected & priced in. Right, but that just means more than 100% of the fall due to the rate increase occurred earlier when it was anticipated, so the rate increase still caused the fall, in effect.
  - whimsicalism 5y ago
    The expectation caused the fall. It's possible to even have an expectation of a rate increase and then not have any at all.
deleted 5y ago
[deleted]
jliptzin 5y ago
Look at the formula for discounted cash flow. It's a widely used valuation model and applies to lots of companies, especially those in the growth phase where current market cap is largely dependent on expected cash flow far into the future. https://en.wikipedia.org/wiki/Discounted_cash_flow https://en.wikipedia.org/wiki/Discounted_cash_flow Notice the denominator in the series - (1+r)^n where r = interest rates and n = number of years out. The more r rises, the more terms at the end of the series drop out because they're so close to zero. So that effectively means a company that's getting its value from cash flow 10+ years from now loses a lot of its value if interest rates are rising.

murgindrag 5y ago

Imagine you're a business with 5 million dollars in revolving debt, at a 2% interest rate. You have $100k in debt service costs. If interest rates go up to 5%, you have $250k in service costs. Most businesses operate close to break-even (in efficient markets), and many will immediately go under. If businesses go under, that triggers a recession cycle: Those businesses lay off employees, who stop buying, driving down revenue for everyone else. People anticipating layoffs/furloughs/etc. stop buying. Hiring goes down too, since businesses start planning for rough times. People buying on credit (anyone with a credit card debt) also find purchasing much more expensive, together with higher bills on existing debt. A whole bunch of business opportunities also disappear in a poof of smoke. If a business has even a 1% expected real return, and interest rates are zero, it makes sense to borrow money to start that business (especially if inflation is also high, giving effective negative interest rates). If a business has an expected 1% return and interest rates are 12%, then I'm bleeding money. For these kinds of opportunities, think less SV startup, and more just normal businesses (e.g. I buy something and sell it a month or two later). All of this piles on to form a recession.

hammock 5y ago
So commercial debt is mostly variable not fixed rate?
- Ekaros 5y ago
  My understanding bonds are mostly fixed rate. Their price on market can vary though. But unlike let's say mortages they are more often refinanced. And when that happens the rates can change.
cannabis_sam 5y ago
> Most businesses operate close to break-even (in efficient markets), and many will immediately go under. Then they are not managing risk properly and actually need to go under.
- ac29 5y ago
  I'm not even sure that its true to a meaningful degree - at least in the US, large businesses dominate economically and are quite profitable (much better than "break even"). Microsoft, Berkshire Hathaway, JP Morgan - they are not going to "go under" if interest rates go up 0.25%, even though they all use corporate debt.