Dec 20, 2022

The Inevitable Recession

It will be nothing short of a miracle if we avoid some form of global recession over the next couple of years.

If you look at your credit card statement from March and compare it to the one from October, you’ll see that your interest rate has risen by at least 2%. In many cases, by 4%.

Actual credit card statements showing rise in interest rates from March 2022-October 2022
Actual credit card statements showing rise in interest rates from March 2022-October 2022

This didn’t happen because you’ve become more risky to lend to or because banks want to extract more money from you, it happened automatically and will almost certainly continue.

On March 15th 2022 the United States Federal Reserve kicked off a global campaign to put a halt to rapidly increasing inflation by raising it’s interest rate by .5%.

44 other central banks around the world joined them.

A new record. The previous all-time high for number of central banks increasing their interest rate in a single month was 37, in December of 2005.

And then it continued. In April of 2022 17 raised again. 50 in May. 56 in June, 42 in July, 29 in August and then a whopping 67 countries increased their policy rate in September.

Number of centrals banks increasing their policy rate by month in 2022.
Number of centrals banks increasing their policy rate by month in 2022.

Such a ferocious, coordinated rise in interest rates from every central bank, has never been seen before.

The main thrust of this campaign is increasing the amount of interest the central banks pay commercial banks—like JP Morgan, Citibank, and Barclay’s—to lend money to the government for the shortest duration loan that exists, overnight.

Which, like it sounds, is the period between the close of business and the next day’s opening of business.

Given the short period of this loan, the interest rate charged in the overnight market is, generally speaking, the lowest rate at which banks lend money.

Today, you can lend money to the United States government—the biggest, most stable government in the world—for the overnight period and receive 3.9% back on that money per year.

Current Overnight Rate

That 3.9% is virtually risk-free, the commercial banks lending money to the US are as certain as one can be that they’ll get their money back. And that’s why the interest you get when you lend money to the US government, is frequently called the risk free rate.

Mortgage loans, car loans, business loans, all other types of loans are mathematically more risky than lending the government money.

At the start of COVID in March of 2020 the US Federal Reserve lowered their overnight rate—or what is technically termed the “Interest on Reserve Balances”—to 0.1% and kept it there for two years. They then quickly raised it to 3.9% over the course of 8 months.

Federal Reserve Overnight Rate (Interest on Reserve Balances) 2019-2022
Federal Reserve Overnight Rate (Interest on Reserve Balances) 2019-2022

So if the risk-free rate has moved from 0% to now 3.9%, how much interest would make sense to charge someone for buying a new car? A used car? A house? Anything they want on their credit card?

Because all of those loans have less likelihood of being paid back than by the US government, the answer has to be—and is—more than 4%.  It’s always more than what the government will pay.

Give or take based on different level of creditworthiness…

A mortgage is often the risk-free-rate + 3%.
A car loan is the risk-free-rate + 6%.
And on and on as the loans being made become more risky.

And because all credit cards are variable rate, this is why the risk-free rate causes interest on credit cards to go up automatically.

The risk-free rate is everything since it pushes up the interest rate charged for everything else.

US 30-Year Mortgage Rate 2011-2022
US 30-Year Mortgage Rate 2011-2022

With even just a 3.9% increase in the overnight rate…

  • Interest payments for current outstanding credit card debt in the United States go up by $40 billion.
  • Mortgaging a $400k house goes from $2,300 per month to $3,300.
  • New car payments go to $900 from $800 per month.

Want to lease instead of buy? Lease payments go up too because companies generally borrow money to finance their operating costs and the rate at which they borrow is affected exactly like consumers is.

The United States is seeing the risk-free rate ratchet higher and credit card balances hit all-time highs. Total revolving consumer credit jumped by more than 17% in Q1 of 2022 and 12.5% in Q3.

US Credit Card and Revolving Debt 2010-2022
US Credit Card and Revolving Debt 2010-2022

Unusual moves considering the average year-over-year change for 2017-2019 was just 4.4%.

People are paying more in interest on new purchases and old purchases and the total combined is higher than it’s ever been. It’s not as big of a deal as adjustable rate mortgages were to the US in 2006-2007 but it’s not nothing either.

Back this out to the entire world where we’ve seen all central banks raise rates at the same time. It’s unprecedented.

Over the past 70 years, the only other time central banks would have had to act like this to bring down inflation was in the 1970’s.

But in the 1970’s many central banks hadn’t even started operating as modern central banks. Placing a hand on the scales with a central interest rate to help guide the economy in a preferred direction.

Indonesia’s first overnight rate was published in 2005. Korea’s in 1999. Brazil 1986. And Mexico’s in 1998.

These economies were barely on the radar in the 70’s, not even talked about. Today, just these four, represent a combined 5% of the world’s economy or nearly $5 trillion in GDP.

Now, for the first time and at the same time, they’re all jacking interest rates up on multi-trillion dollar globally interconnected economies because inflation has forced them to.

So when we add together the cost of inflation over the past year—the price of everything has gone up by at least 10%—and then we add in the cost of borrowing going up at least 4%, there are very large cost pressures sitting on top of everyday spenders and businesses.

As a global economy, we’re running this experiment for the first time. The United States housing market finally cracked in the 2000’s largely because interest rates triggered payment increases that were too high for overstretched borrowers.

One of the candidates for experiencing that on their own terms this time around is Australia where 40% of housing loans issued since the start of the pandemic were in variable rate loans that will reset by the end of 2023. Taking on the prevailing interest rate at that time.

The Reserve Bank of Australia has even come out and said that if they have to raise their rates to 3.5%, from it’s current 2.85%—which is what the market is expecting… “Just under 30 per cent of borrowers would face relatively large repayment increases of more than 40 per cent of their current payments” and that “housing mortgage payments as a share of household income were expected to increase to around levels last seen in 2010

This is just Australia.

Finland, Canada, Norway, are all in similar predicaments regarding adjustable rate mortgages.

For the United States on the other hand, just 2% of mortgages are floating rate.

Share of mortgage since 2020 issued at an adjustable rate
Share of mortgage since 2020 issued at an adjustable rate

To top it off, Australia, Canada, and Norway hold the ranking for most indebted households in the world. Coming in at 2nd, 3rd, and 9th.

This adjustable rate mortgage situation and US credit card debt are just two examples in a world of 200 countries. A major crash doesn’t have to occur, but it will be nothing short of a miracle if we avoid some form of global recession over the next couple of years.

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