Building Wealth The rising-interest-rate goose is going to be cooked in 2022. That's right – if you believe the Federal Reserve – interest rates are going rise.
That's good and bad, all at once. And, as I (Kim Iskyan) will explain, it's also likely and unlikely, all at once...
It's been 15 years since the return on cash has been anything more than pocket change. To an entire generation, the notion of "living off investment income" sounds about as realistic as truth in politics.
In 2007, you could have put money into a savings account, a certificate of deposit ("CD"), or a bond or bond fund and earned about 5%... Since then, returns have been less than 1%.
Today, if you put $100 into an average one-year CD – which is a fixed-term bank deposit at a preset interest rate – at the end of that year, you'd get back around $100.14... for a 0.14% return. If you were ready to lock your cash up for five years, you could earn a whopping 0.26% per year.
Buying a bond will get you a higher yield... and more risk, of course. The iShares Core U.S. Aggregate Bond Fund (AGG), a big corporate bond fund, has a yield of 1.8%... But shareholders of the fund have lost nearly 1.8% over the past year. (The end of the longest bull market in U.S. history has a big role to play in that.)
Hello, High(er) Interest Rates?
The last time the average interest rate on a one-year CD topped 1% was back in May 2009.
That may soon begin to change, though... "I would say that the committee is of a mind to raise the federal-funds rate [which is the key driver of interest rates] at the March meeting, assuming that the conditions are appropriate for doing so," Federal Reserve Chairman Jerome Powell said in late January.
The Fed is aiming to end its economy-supporting asset purchases ($60 billion in bonds and mortgage-backed securities a month) in March. And it will raise benchmark interest rates this year – probably at least twice (by 0.25% each time) – and perhaps by as much as six times, some forecasters think.
An increase in the middle of that range would lift interest rates to around the 0.75% to 1% level... which means that you might be able to make close to 1% with a CD next year.
That's about a buck in return for having tied up $100 for a year. By 2023, interest rates could be as high as 2%.
That's not going to allow for a Michelin-star lifestyle from your bond portfolio, but it's better than today at least.
The Fed is concerned about inflation, which for December, clocked in at an annual rate of 7% – the highest in nearly four decades. Raising interest rates is one of the tools in the Fed's arsenal to strengthen the buying power of the dollar – which in turn offsets inflation.
What Higher Interest Rates Mean
Higher interest rates mean that it will cost more to borrow. As a result, companies and people will borrow less – and they'll also spend less. All else being equal (which is rarely the case outside of economics textbooks), that will reduce the upward pressure on inflation.
That also means that mortgage rates will rise. When it costs more to buy real estate – when the cost to borrow money is higher – fewer people will buy and demand will decline... meaning home prices could fall as a result.
And a rate increase can drag down share prices. As interest rates rise and investors can earn higher rates of return – "risk free" – on their money, they'll take some cash out of higher-risk assets (like stocks) and put it in safer investments.
That's not to say that tens of billions of dollars of speculative money in Robinhood accounts will suddenly flow from meme stocks like GameStop (GME) and AMC Entertainment (AMC) into 1% CDs... Don't hold your breath.
But there will always be some nervous cash ready to walk away from, say, dividend-yielding stocks in favor of something safer. And the higher rates go ‒ and as fears of a significant drop in the overall equity market intensify ‒ the more people will move from stocks to a safer haven.
How the Federal Budget Is at Risk
Higher rates have the scope to doom the federal budget – in more ways than one.
In 2020, the U.S. government's federal budget amounted to $6.6 trillion, according to the nonpartisan Congressional Budget Office. Of that, $4.6 trillion was for what's called "mandatory spending" – including entitlement programs like Social Security, Medicare, and Medicaid.
Another $1.6 trillion was in "discretionary" spending, which encompasses defense and everything else – from health to justice to agriculture to education.
Well, that is... "everything else" except for $345 billion in interest payments on federal debt, which currently stands at over $29 trillion. At just 5.3% of total spending, interest payments might sound like a rounding error.
But that sum, according to the nonpartisan think tank Committee for a Responsible Federal Budget ("CRFB"), is more than four times what the government will spend on housing... also more than four times what Uncle Sam spends on K-12 education... and eight times what it will spend on science, space, and technology.
In other words, $345 billion in interest payments might not buy what it used to, but it's still a mighty large sum of money.
As rates rise, those interest expenses rise as well. And the thing is... that $345 billion the government pays in debt service is at historically low interest rates. But with the Fed raising interest rates, that's going to change as well – along with the cost of mortgage and the yield on a CD.
What Higher Rates Do to the Budget
A one-percentage-point rise in interest rates – which, according to the Federal Reserve, we could possibly see next year – would boost the amount of money paid on interest on the federal government debt to $530 billion.
That's more than the cost of Medicaid, according to CRFB. And a two-percentage-point increase – entirely possible by 2023, under current projections – would raise it to $750 billion. That's about as much as all government spending on defense.
Three percentage points higher, and the government would be spending nearly $1 trillion on interest expenses alone... which is around 20% of total federal tax revenue and approximately as much as is spent on Social Security benefits every year.
Put it all together, and the numbers don't add up – short of a cataclysmic tax hike that would be political suicide.
A Lot of Bad Options
The Federal Reserve could, in theory, print as many dollars as the government needs to make its interest payments. But Uncle Sam having to bail itself out like that will likely lead once again to – you guessed it – inflation.
Another alternative is to cut spending. But there's not a lot of wiggle room – subtract "mandatory spending" and defense spending (which is "mandatory" in fatigues, after all), and there's only 20% of the budget left. And that 20% pays for, well, everything else.
The federal government staring down the barrel of a true debt crisis could imperil the stability of the U.S. dollar and throw into further doubt the status of the dollar as the world's reserve currency. Last April, I told American Consequences readers that the U.S. dollar had already worn out its welcome as the global reserve currency.
And higher interest rates could be what finally tips it over the edge.
And what about just raising more debt? Last month, Congress passed a measure that raises the federal government's overall borrowing limit by $2.5 trillion. That doesn't allow for new spending – but rather, it means that the government can issue new debt so that it can pay for Social Security and other obligations... like interest on debt.
The measure to increase the debt limit – a highly partisan effort with peacock-like posturing by both political parties – means that Congress has delayed the next debt-ceiling standoff until after the November 2022 midterm elections. And any real discussion of the cost of debt is delayed until, well, forever.
Can Interest Rates Go Higher?
That begs the question... will interest rates really rise? The Fed says it wants to – and markets, it seems, are ready. But if the federal budget just can't handle higher interest rates, something has to give.
But believe it or not, some companies may be in even bigger trouble than Uncle Sam...
As my colleague Mike DiBiase, the editor of Stansberry's Credit Opportunities, explained in July...
U.S. companies have simply gorged on debt since the last financial crisis. Corporate debt is up 70% since the end of 2008... It now tops $11 trillion.
This is just an acceleration of a trend that goes back four decades. Corporate debt has increased nearly 1,200% over this period.
And they've been able to do that because, of course, interest rates have been so darn low. When it costs so little to borrow... well, why not borrow more? Borrowed money can fund growth.
But a lot of this corporate debt won't be repaid, Mike says... The credit quality of corporate debt is at historically low levels. Even at record-low interest rates, around a quarter of all companies in the Russell 3000 Index are "zombie companies" – which means that they don't earn enough profits to cover interest payments, to say nothing of the full borrowed amount.
As Mike explains, if the Fed raises interest rates and these zombies face higher interest payments...
The cost of the debt will be too much for many borrowers to handle. Higher rates will set off a wave of bankruptcies like we've never seen before.
The Solution: None of the Above
The Fed doesn't have to raise interest rates... The White House could try to raise taxes... Inflation could continue to rise.
In other words... it's like choosing between fried liver, boiled Brussels sprouts, and a day-old mayonnaise sandwich: There are no good options.
Regards,
Kim Iskyan
Editor's note: According to our colleague Dan Ferris, the market is deep into "bubble" territory. And no matter when the next crash arrives, out-of-control inflation is already here. But there's one group of stocks that could protect your savings and likely outperform everything else for the next five to 10 years... Click here to learn more.