4 ms·

The explanation I keep seeing is "the United States Federal Reserve raised the Federal Funds Rate from 0.25% to 4.75% in the past 6-18 months, therefore, these

The explanation I keep seeing is "the United States Federal Reserve raised the Federal Funds Rate from 0.25% to 4.75% in the past 6-18 months, therefore, these companies are reacting to that and having to cut back on costs" where it falls apart in my mind is (and I might be missing something) why is that having such a massive impact so quickly on these companies to the point where, the cost to service NEW debt (not existing) rises? i thought a lot of these companies had so much cash due to high tech margins that, they didn't really finance growth through cheap debt?

lkrubner 4y ago
The stimulus in 2020 and 2021 was historic and caused rapid economic growth, therefore companies hired in response to that growth. The rise in interest rates from 0.25% to 4.75% is meant to slow economic growth, therefore companies need to adjust to a period of slower growth. The higher interest rates work primarily through the real estate market, slowing construction, but this means less consumers, and therefore less income for companies. Keep in mind, the banks raised rates rapidly as soon as they knew the Fed was going to raise rates. The Fed took many months to get to 4.75% but the banks jumped ahead and raised rates almost instantly. In 2020 many CEOs needed to plan for hypergrowth, in 2023 many CEOs need to plan for a possible recession. The money I spend becomes income for a company, and when that company pays you a salary, and you buy something from my company, then they money you spend becomes my salary. Everything goes around in a circle. Therefore, it doesn't matter how much debt a company has, but it does matter how much debt other people have. If other people suddenly need to pay more interest on their debts, then they have less money to spend whatever it is that your company is selling (unless you work at a bank).
- dboreham 4y ago
  > hired in response to that growth I think it's more direct than that. Rich people weren't getting any return on their money from fixed income instruments so instead they gave it to funds that invested in tech startups that then used it to hire people. Now interest rates are higher, rich people don't need to do that any more.
  - emodendroket 4y ago
    Yes, that’s ultimately the theory behind rate hikes in the first place. On a big enough scale, wages get driven downward and then that has a knock-on effect on prices. It just turns out tech was especially vulnerable.
    - short_sells_poo 4y ago
      > It just turns out tech was especially vulnerable. This should not be surprising at all! The entire tech rally was fueled by a huge amount of leverage. That leverage was very cheap in the last 10 years, because there was a lot of money sloshing around and the interest rates were zero (sometimes even negative), which meant that the bar on portfolio returns was very low. I'm going to simplify a lot: let's say you have a portfolio that returns 10% p.a., if the risk free rate (ie bond returns) are 0, then you can say that your portfolio gives people 10% in excess of what they could get by holding safe assets. But now rates are 5% (for the sake of simplicity), that same portfolio only gives you 5% excess returns. On any single given year that's not a huge difference, but if you compound this over 10 years, that's the difference of having earned 60% vs. 160%. Huge difference! So as you can see this relatively small (in absolute terms) change really compounds itself into a massive re-evaluation of investments. When rates are negative, you'd be happy to hold assets that merely do nothing - ie neither gain nor lose value - but once rates start to rise appreciably, the future value of those investments needs to be discounted and because we are dealing with compounding, the discounting itself can be pretty brutal. This is then further compounded by the expectation that money supply itself is shrinking, which makes the pool of available money smaller as well. It's really a double whammy which will mostly affect highly leveraged and risky bets, as they become much much less palatable. It was really perverse how many tech companies had no discernible avenue of ever becoming profitable, and yet had billion dollar valuations. People were looking desperate for parking capital anywhere they could.
      - MuffinFlavored 4y ago
        > The entire tech rally was fueled by a huge amount of leverage I'd like to see a source/citation/proof for for that claim. I find it hard to believe Apple, Microsoft, Google, or Meta have "huge leverage".
- MuffinFlavored 4y ago
  > Keep in mind, the banks raised rates rapidly as soon as they knew the Fed was going to raise rates. The Fed took many months to get to 4.75% but the banks jumped ahead and raised rates almost instantly. "Banks are intermediaries between the central bank (such as the Federal Reserve) and consumers and businesses. Banks borrow funds from the central bank at a certain rate and then lend those funds to their customers at a higher rate, earning a profit on the spread between the two rates." > therefore companies need to adjust to a period of slower growth. I think this is the missing piece for me. I didn't realize that since consumers will purchase less houses, the real estate sector will lag, and those who earn their living in it will have less discretionary spending to pump into the economy. From there (at scale), companies like Microsoft will grow less due to weakened consumer demand. That and people who need to finance car purchases right now (new or used) would also be affected. If it costs them more to finance a car than it did 12 months ago, Microsoft/Amazon/Google/Facebook can expect to have weakened consumer demand. So it isn't that Microsoft itself is directly impacted at a "we finance debt to pay our employees with the Federal Funds rate", but more that the Federal Reserve is trying to weaken consumer demand. Once that weakened demand reaches Microsoft, they need to adjust (lay off unprofitable teams/projects) to stay on their previously baked in growth projections that Wall Street expects to see/demands. Without this, Microsoft stock will go backwards because Wall Street wants to see perpetual continuous growth.
  - lkrubner 4y ago
    "Banks borrow funds from the central bank at a certain rate" Right, but banks don't have to borrow money from the Fed. Banks also have the deposits from their customers, and so banks can make new loans based on those deposits. Last time I checked, this was roughly a 5 to 1 ratio (a bank with $1 million in deposits could make loans of $5 million) but that changes all the time, based on limits set by the Fed. But in general, right, when the Fed raises rates, consumer demand will weaken, and then that spreads to the retail sector, and then that works backwards to the manufacturing sector and all the service sector activities that support businesses in general (accounting, legal, janitors, etc), eventually slowing all economic activity.
    - 4y ago
Conan_Kudo 4y ago
> why is that having such a massive impact so quickly on these companies to the point where, the cost to service NEW debt (not existing) rises? It's because a lot of tech companies have built their financial management on regularly refinancing and getting new cash through the debt market to keep things going, rather than minimizing the usage of debt markets for cash generation.
- MuffinFlavored 4y ago
  I don't think we have any proof that a company as profitable and large as Microsoft, based on their financial reports, is using cheap short term debt to finance projects (payroll expenses included)/accelerate growth? Or are they?
nemo44x 4y ago
It's more about that there's a cascading effect going on right now where your customers are scaling back because their customers are scaling back because their customers are scaling back, etc. So because of that, everyone is expecting a decline in growth that was planned for and hired for. Companies still do have lots of cash but they need to manage that cash with the expectation that they won't be able to raise cash as easily in the near/mid future. Valuations are cut because there's better places to put money now to get yield so when you do raise, you'll need to sell an even bigger piece of the company to get the funds you need.
sumtechguy 4y ago
Existing debt coming due as well as a change in market. These are more than likely not 30+ year loans. Probably anything from overnight to 2-10 year. It is also possible to be 'cash poor' but have lots of invested value. That trap puts you in a spot where you borrow money to make payroll, even though you have enough. That gotcha put a lot of companies out of businesses in 2008. When it became very difficult to even borrow money. Higher rates also make it harder to borrow especially if you are carrying an existing debt load. This is just speculation on my part but also perhaps instead of investing the money in the company it is better to just buy bonds for a better rate of return? Basically instead of buying workers time to get a rate of return. That worker has to 'beat' the interest rate which factors into MR=MC to make it worth the while of the company to keep them around. Wonder if there are any economic studies on that.
- MuffinFlavored 4y ago
  > This is just speculation on my part but also perhaps instead of investing the money in the company it is better to just buy bonds for a better rate of return? That is what I was trying to get an answer on. That is rooted on the premise that it needs to be a truthood/assumption that Microsoft's projects net them less than the risk free rate (which is 4.5%). That seems low.
onlyrealcuzzo 4y ago
It's not a debt problem for tech companies. It's a valuation problem with how much FUTURE profits are valued vs CURRENT profits. Losing money now to make money in the future isn't sexy anymore. So you have to fire people until you make money now. For companies like FAANG - which are ridiculously profitable - it's still the same. Future profits aren't worth as much. Current profits are worth more. Now it's sexy to fire people to make more money now, because that's valued higher than before.
- MuffinFlavored 4y ago
  > Losing money now to make money in the future isn't sexy anymore. So you have to fire people until you make money now. I am familiar with this concept but I'm curious if you could teach me more on the specifics. I think what you are referring to is basically "cost of capital analysis". If the companies weren't hiring/paying payroll with debt at 0.5%, why does the fact matter that debt would now hypothetically cost them 5% come into play? Are they up against the fact that their projects (after payroll and all expenses) need to return more than the risk free rate (4-5%)? Why would that matter? Are tech projects really that unprofitable? I figured most projects at tech companies are easily 20%+ in terms of margin. > For companies like FAANG - which are ridiculously profitable - it's still the same. Would you go as far as to say Microsoft laying off 10,000 and Amazing laying off 18,000 people had next to nothing to do with the federal funds rate then?
  - dcliu 4y ago
    I am just learning about too, but I think the explanation goes something like this: Because the risk-free rate of return is now much higher, the net present value of the estimated future cash returns from that investment has gone down. Another way to look at it, earning a dollar today is now worth much more than earning a dollar in five years. Just how much has it increased? If we use the 3-month Treasury bill rate as the risk-free return, it has gone from 0.05% to 4.64%. A dollar in five years used to be worth (1 / 1.0005^5) and now it is only worth (1 / 1.0464^5). That's a drop of 25%, definitely significant enough to make some speculative and longer-term investments no longer pencil out.
emodendroket 4y ago
Because unprofitable investments that theoretically MIGHT be profitable in the future, something tech was full of, are much less attractive in this environment and investors are no longer throwing money at them.
balderdash 4y ago
Tech stocks are long duration assets (e.g.they have high interest rate sensitivity (if investment one pays me $10 a year for the next 20 years versus investment two which pays me $200 in year 20, in a 0% interest world they’re worth the same, in a 5% discount rate world, option one is dramatically more attractive and the NPV change in investment two, is far more severe than in investment one)) This is part of why valuations in tech land have been cut so much. If you are the management of a public company, and you are trying to increase your stock price, the answer is to make the your cash flow profile look more like option 1 vs option 2 above. One (perhaps shortsighted) way of doing that is to cut cost via layoffs…

lkrubner 4y ago

The stimulus in 2020 and 2021 was historic and caused rapid economic growth, therefore companies hired in response to that growth. The rise in interest rates from 0.25% to 4.75% is meant to slow economic growth, therefore companies need to adjust to a period of slower growth. The higher interest rates work primarily through the real estate market, slowing construction, but this means less consumers, and therefore less income for companies. Keep in mind, the banks raised rates rapidly as soon as they knew the Fed was going to raise rates. The Fed took many months to get to 4.75% but the banks jumped ahead and raised rates almost instantly. In 2020 many CEOs needed to plan for hypergrowth, in 2023 many CEOs need to plan for a possible recession. The money I spend becomes income for a company, and when that company pays you a salary, and you buy something from my company, then they money you spend becomes my salary. Everything goes around in a circle. Therefore, it doesn't matter how much debt a company has, but it does matter how much debt other people have. If other people suddenly need to pay more interest on their debts, then they have less money to spend whatever it is that your company is selling (unless you work at a bank).

dboreham 4y ago
> hired in response to that growth I think it's more direct than that. Rich people weren't getting any return on their money from fixed income instruments so instead they gave it to funds that invested in tech startups that then used it to hire people. Now interest rates are higher, rich people don't need to do that any more.
- emodendroket 4y ago
  Yes, that’s ultimately the theory behind rate hikes in the first place. On a big enough scale, wages get driven downward and then that has a knock-on effect on prices. It just turns out tech was especially vulnerable.
  - short_sells_poo 4y ago
    > It just turns out tech was especially vulnerable. This should not be surprising at all! The entire tech rally was fueled by a huge amount of leverage. That leverage was very cheap in the last 10 years, because there was a lot of money sloshing around and the interest rates were zero (sometimes even negative), which meant that the bar on portfolio returns was very low. I'm going to simplify a lot: let's say you have a portfolio that returns 10% p.a., if the risk free rate (ie bond returns) are 0, then you can say that your portfolio gives people 10% in excess of what they could get by holding safe assets. But now rates are 5% (for the sake of simplicity), that same portfolio only gives you 5% excess returns. On any single given year that's not a huge difference, but if you compound this over 10 years, that's the difference of having earned 60% vs. 160%. Huge difference! So as you can see this relatively small (in absolute terms) change really compounds itself into a massive re-evaluation of investments. When rates are negative, you'd be happy to hold assets that merely do nothing - ie neither gain nor lose value - but once rates start to rise appreciably, the future value of those investments needs to be discounted and because we are dealing with compounding, the discounting itself can be pretty brutal. This is then further compounded by the expectation that money supply itself is shrinking, which makes the pool of available money smaller as well. It's really a double whammy which will mostly affect highly leveraged and risky bets, as they become much much less palatable. It was really perverse how many tech companies had no discernible avenue of ever becoming profitable, and yet had billion dollar valuations. People were looking desperate for parking capital anywhere they could.
    - MuffinFlavored 4y ago
      > The entire tech rally was fueled by a huge amount of leverage I'd like to see a source/citation/proof for for that claim. I find it hard to believe Apple, Microsoft, Google, or Meta have "huge leverage".
MuffinFlavored 4y ago
> Keep in mind, the banks raised rates rapidly as soon as they knew the Fed was going to raise rates. The Fed took many months to get to 4.75% but the banks jumped ahead and raised rates almost instantly. "Banks are intermediaries between the central bank (such as the Federal Reserve) and consumers and businesses. Banks borrow funds from the central bank at a certain rate and then lend those funds to their customers at a higher rate, earning a profit on the spread between the two rates." > therefore companies need to adjust to a period of slower growth. I think this is the missing piece for me. I didn't realize that since consumers will purchase less houses, the real estate sector will lag, and those who earn their living in it will have less discretionary spending to pump into the economy. From there (at scale), companies like Microsoft will grow less due to weakened consumer demand. That and people who need to finance car purchases right now (new or used) would also be affected. If it costs them more to finance a car than it did 12 months ago, Microsoft/Amazon/Google/Facebook can expect to have weakened consumer demand. So it isn't that Microsoft itself is directly impacted at a "we finance debt to pay our employees with the Federal Funds rate", but more that the Federal Reserve is trying to weaken consumer demand. Once that weakened demand reaches Microsoft, they need to adjust (lay off unprofitable teams/projects) to stay on their previously baked in growth projections that Wall Street expects to see/demands. Without this, Microsoft stock will go backwards because Wall Street wants to see perpetual continuous growth.
- lkrubner 4y ago
  "Banks borrow funds from the central bank at a certain rate" Right, but banks don't have to borrow money from the Fed. Banks also have the deposits from their customers, and so banks can make new loans based on those deposits. Last time I checked, this was roughly a 5 to 1 ratio (a bank with $1 million in deposits could make loans of $5 million) but that changes all the time, based on limits set by the Fed. But in general, right, when the Fed raises rates, consumer demand will weaken, and then that spreads to the retail sector, and then that works backwards to the manufacturing sector and all the service sector activities that support businesses in general (accounting, legal, janitors, etc), eventually slowing all economic activity.
  - 4y ago

Conan_Kudo 4y ago

> why is that having such a massive impact so quickly on these companies to the point where, the cost to service NEW debt (not existing) rises? It's because a lot of tech companies have built their financial management on regularly refinancing and getting new cash through the debt market to keep things going, rather than minimizing the usage of debt markets for cash generation.

MuffinFlavored 4y ago
I don't think we have any proof that a company as profitable and large as Microsoft, based on their financial reports, is using cheap short term debt to finance projects (payroll expenses included)/accelerate growth? Or are they?

nemo44x 4y ago

It's more about that there's a cascading effect going on right now where your customers are scaling back because their customers are scaling back because their customers are scaling back, etc. So because of that, everyone is expecting a decline in growth that was planned for and hired for. Companies still do have lots of cash but they need to manage that cash with the expectation that they won't be able to raise cash as easily in the near/mid future. Valuations are cut because there's better places to put money now to get yield so when you do raise, you'll need to sell an even bigger piece of the company to get the funds you need.

sumtechguy 4y ago

Existing debt coming due as well as a change in market. These are more than likely not 30+ year loans. Probably anything from overnight to 2-10 year. It is also possible to be 'cash poor' but have lots of invested value. That trap puts you in a spot where you borrow money to make payroll, even though you have enough. That gotcha put a lot of companies out of businesses in 2008. When it became very difficult to even borrow money. Higher rates also make it harder to borrow especially if you are carrying an existing debt load. This is just speculation on my part but also perhaps instead of investing the money in the company it is better to just buy bonds for a better rate of return? Basically instead of buying workers time to get a rate of return. That worker has to 'beat' the interest rate which factors into MR=MC to make it worth the while of the company to keep them around. Wonder if there are any economic studies on that.

MuffinFlavored 4y ago
> This is just speculation on my part but also perhaps instead of investing the money in the company it is better to just buy bonds for a better rate of return? That is what I was trying to get an answer on. That is rooted on the premise that it needs to be a truthood/assumption that Microsoft's projects net them less than the risk free rate (which is 4.5%). That seems low.

onlyrealcuzzo 4y ago

It's not a debt problem for tech companies. It's a valuation problem with how much FUTURE profits are valued vs CURRENT profits. Losing money now to make money in the future isn't sexy anymore. So you have to fire people until you make money now. For companies like FAANG - which are ridiculously profitable - it's still the same. Future profits aren't worth as much. Current profits are worth more. Now it's sexy to fire people to make more money now, because that's valued higher than before.

MuffinFlavored 4y ago
> Losing money now to make money in the future isn't sexy anymore. So you have to fire people until you make money now. I am familiar with this concept but I'm curious if you could teach me more on the specifics. I think what you are referring to is basically "cost of capital analysis". If the companies weren't hiring/paying payroll with debt at 0.5%, why does the fact matter that debt would now hypothetically cost them 5% come into play? Are they up against the fact that their projects (after payroll and all expenses) need to return more than the risk free rate (4-5%)? Why would that matter? Are tech projects really that unprofitable? I figured most projects at tech companies are easily 20%+ in terms of margin. > For companies like FAANG - which are ridiculously profitable - it's still the same. Would you go as far as to say Microsoft laying off 10,000 and Amazing laying off 18,000 people had next to nothing to do with the federal funds rate then?
- dcliu 4y ago
  I am just learning about too, but I think the explanation goes something like this: Because the risk-free rate of return is now much higher, the net present value of the estimated future cash returns from that investment has gone down. Another way to look at it, earning a dollar today is now worth much more than earning a dollar in five years. Just how much has it increased? If we use the 3-month Treasury bill rate as the risk-free return, it has gone from 0.05% to 4.64%. A dollar in five years used to be worth (1 / 1.0005^5) and now it is only worth (1 / 1.0464^5). That's a drop of 25%, definitely significant enough to make some speculative and longer-term investments no longer pencil out.

emodendroket 4y ago

Because unprofitable investments that theoretically MIGHT be profitable in the future, something tech was full of, are much less attractive in this environment and investors are no longer throwing money at them.

balderdash 4y ago

Tech stocks are long duration assets (e.g.they have high interest rate sensitivity (if investment one pays me $10 a year for the next 20 years versus investment two which pays me $200 in year 20, in a 0% interest world they’re worth the same, in a 5% discount rate world, option one is dramatically more attractive and the NPV change in investment two, is far more severe than in investment one)) This is part of why valuations in tech land have been cut so much. If you are the management of a public company, and you are trying to increase your stock price, the answer is to make the your cash flow profile look more like option 1 vs option 2 above. One (perhaps shortsighted) way of doing that is to cut cost via layoffs…