The Real Cost of Fed Rate Hikes

25 jul 2022

10Y1! 2YY1!
The Federal Open Market Committee (FOMC) is scheduled to meet on July 26-27. Market widely expects a 75-basis-points (bps) Fed Funds rate increase, from current target of 1.50%-1.75% to 2.25%-2.50%. The call for a 100-point hike, while still feasible, is weakened after U.S. gasoline price dropped 70 cents per gallon in the past month. New data hints that the runaway inflation may be contained.

Federal funds Rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. It is the most important global interest rate benchmark, as it directly or indirectly influences the borrowing cost for governments, corporations, and households. By the end of July, Fed Funds would have gone up by 2.25% (assuming 75 bps hike in July) from zero before March. The Fed is not afraid of raising rate even higher until inflation moves back to its 2% policy target.

How much will a higher interest rate cost for government, business, or household? I will illustrate the impact of 100bps rate increase in this analysis. All data comes from either the Fed or USdebtclock.org, unless otherwise noted.

Total Debt: By the end of Q1 2022, the total debt outstanding in the U.S. by both public and private sectors is $90.1 trillion. Mind-boggling. What does the number mean?
• U.S. GDP was $23.0 trillion in 2021. Debt-to-GDP ratio is 3.92. It would take all Americans four years to pay off their debt, without spending or paying interest.
• US population is 332,403,650 as of January 2022 per US Census Bureau. Debt per capita is $270,949. Each time a baby is born, he or she already owes more than a quarter million dollar.

US National Debt: $30.6 trillion based on USdebtclock.org real-time calculation. This is just the debt owed by Federal government and various federal agencies.
• National Debt to GDP ratio: 133%.
• Federal tax revenue is estimated at $4.4 trillion in 2022. If our government just levies taxes and does nothing else, it will take seven years to pay off the debt.
• Federal budget is $6.0 trillion in 2022, with budget deficit running at $1.6 trillion. Interest on debt is $440 billion, the fourth largest budget item. If interest rate goes up 100 bps across the yield curve, federal government will have to come up with $306 billion extra to service the debt.
• Federal budget in 2022: $6.0 trillion
o budget deficit $1.6 trillion
o Interest on debt $440 billion (4th largest budget item)
o Remark: $306 billion extra to service the debt, if interest rate goes up by 100bps
• When all the rate hikes are over, annual debt interest payment could be over $1.0 trillion. It would become the 3rd largest budget item, behind Medicare ($1.4 trillion), Social Security ($1.0 trillion) and ahead of Defense ($751 billion)!

State and Local Government debt: $3.3 trillion, of which $2.1 trillion from state governments and $1.2 trillion from local governments.
• If interest rate goes up by 100 bps, state and local governments will have to come up with $33 billion extra to service their debt.
• We may expect tax hikes from state and local governments, while public services may be cut back at the same time.

US Corporate Debt: $11 trillion, which includes all debt issued by non-financial corporations domiciled in the U.S.
• If interest rate goes up by 100 bps, American businesses will have to come up with $110 billion extra to service their debt.
• We may expect higher prices for goods and services, as businesses pass on the interest cost to consumers.
• Companies with high debt ratio may increase the chance of delinquency.

US Household Debt: $23.5 trillion. This includes mortgage, auto loan, credit card loan and student loan, etc.
• Personal debt per citizen is $70,304. If interest rate goes up by 100 bps, each person will have to come up with $703 extra a year to service their debt.
• American families are fighting with a higher cost-of-living on multiple fronts. If the U.S. falls into a recession, their financial situation will worsen significantly.
• Mortgage delinquency is expected to rise significantly.

The remainder, approximately $21 trillion, is outstanding balance of credit instruments issued by banks and other financial institutions.

Believe it or not, we have only just scrubbed the surface of our mounting debt problem. Most government liabilities are unfunded or underfunded. Each year, the Federal Government borrows new money to pay off the maturing debt.

Medicare, Medicaid, and Social Security are pay-as-you-go programs. Government taxes current workers to pay for the benefits of retirees, without any money saving up for current workers. No one has a crystal ball if the benefits are still there when they reach retirement.

With such a depressing future ahead of us, are there any trading opportunities? The answer is yes. I am counting on the inverted yield curve to return to historical normal.

Yield curve plots the interest rates on government bonds with different maturity dates, notably three-month Treasury Bills, two-year and 10-year Treasury Notes, 15-year and 30-year Treasury Bonds. Bond investors expect to be paid more for locking up their money for a long stretch, so interest rates on long-term debt are higher than those on short-term. Plotted out on a chart, the various yields for bonds create an upward sloping line.

Sometimes short-term rates rise above long-term ones. That negative relationship is called yield curve inversion. An inversion has preceded every U.S. recession for the past half century, so it’s seen as a leading indicator of economic downturn.

On July 21st, the yield on two-year Treasury notes stood at 3.00 percent, above the 2.91 percent yield on 10-year notes. By comparison, two-year yields were one percentage point lower than the 10-year yields a year ago.

Why are we seeing yield curve inversion now? Short-term yield directly responded to Fed rate hikes. It has gone up 225 bps in five months. Longer term yields are determined by credit market supply and demand. The prospect of an upcoming recession held off lending by businesses and households alike, keeping the yields relatively stable.

In my opinion, yield curve inversion could not sustain for long. Borrowers would flock to lower rate debt, pushing up demand for longer term credit. Market force would revert the yield curve to a normal one with interest rates on long-term debts higher than those on short-term ones.

Are there any instruments we could leverage to trade the reversal of yield curve inversion? Long the Spread of CBOT Micro 10-Year Yield (10Y) and 2-Year Yield (2YY).

Traditional Treasury Futures are quoted in Treasury Notes price, which can be viewed as the present value of future payments that bondholder will receive – interest payment every six months and the return of principal at par value at maturity.

Micro Yield Futures are more intuitive. They are quoted in yield directly. On July 22nd, August 10Y Yield Futures (10YQ2) was settled at 2.819. August 2Y Yield Futures (2YYQ2) was settled at 3.06. The 10Y-2Y spread is -0.241.

The 10Y-2Y spread has been positive in recent years. It turned negative in the beginning of July as we experienced the inverted yield curve. I expect the spread to return to historic normal - a positive number, in the coming months.

To trade Micro Yield futures, margins are $240 for 10Y and $330 for 2YY. A long spread can be constructed by a Long 10Y and a Short 2YY positions.

The great thing about a spread trade lies with the fact that you don’t have to be right in predicting the direction of interest rates. Spread will be widened if 10Y rises faster than 2YY. Even in a falling rate environment, if 10Y fell less than 2YY, the spread will be enlarged too.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.