North America Cracks of driving liquidity

A few segments of the US economy show some signs of fragility amid higher rates

 

A significant increase of the Libor rate

The recent announcements made by the White House on trade protectionism have triggered a sudden surge in the level of uncertainty, harshly penalizing equity markets and increasing the demand for safe haven assets. As a result of this, US long-term interest rates have markedly declined over the last month from 1.9% to 1.8%. In the opposite way, and despite rising uncertainties, US short-term interest rates have continued increasing, in particular the LIBOR rate, which today reaches 2.35%. This trend reflects above all the confidence of the market in the Fed’s capacity to continue its monetary policy normalization with a gradual increase of official rates. We still expect two more hikes in 2018.

More worryingly, the LIBOR – OIS spread currently reveals increasing difficulties of banks in accessing short-term liquidities on the money market. During the subprime crisis, this indicator played the role of a bell-weather on the health of US banks as sudden reversal of confidence in any financial conditions could lead to a market freezing, with strongly negative impacts on banks’ credit conditions and on the real side of the economy. Today, this indicator has lost of its relevancy because of regulatory changes, which have transformed the way money market funds interact with banks. Despite this new element, the widening of the LIBOR – OIS spread still contains some information in terms of liquidity conditions, as evidenced by our proprietary indicator of excess supply of money.

In order to identify the impact of the Fed’s tightening policy (progressive increase of official rates and reduction of the Fed’s balance sheet), we estimate a theoretical money demand based on M0 and quantity theory of money, i.e. we calculate a theoretical M0 (transactional money demand), which is determined by the relation MV = PT with M corresponding to M0, V indicating the velocity of M0, P the level of prices and T the level of transactions or nominal GDP. We study this relation in variation and compare the observed evolution of M0 and the theoretical one justified by activity and speed of money circulation. To this regard, it appears that we are currently at an interesting juncture, where the excess of liquidity is now close to 0 after long years of money excess supply, during which debt and therefore investment financing were particularly cheap. Our indicators therefore points toward an end of the cheap money, which could have a significant impact on the real side of the company, for those economic actors which rely the most on debt.

The high yield sector is probably one of the most exposed segments of the US economy to an interest rate shocks as it benefitted from exceptionally advantageous interest rate conditions. On the basis of a bottom up process using financial data from companies listed in the S&P500, we can have a view on the relative level of leverage of sectors calculated as the ratio of net debt to ebitda. To this regard, the utilities sector is the most leveraged, followed by materials and energy, confirming the existence of high indebtedness in sectors which are relatively more capital intensive.

We study the sensitiveness of CDS spreads by sector to LIBOR rates and find that indeed a context of higher rates leads to an increase of the probability of default in only two sectors, i.e. consumer discretionary and utilities, while energy sector is likely to suffer as well. Our data basis confirms than energy and retail registered the highest number of major insolvencies (with services, which is a collection of disparate activities), respectively 5 and 16 in 2017.

REIT prices falling

Because of their exposure to retail activities and their sensitiveness to rates, REITs (Real Estate Investment Trusts) could be exposed to interest rate shocks. They are similar to mutual funds although they invest primarily in commercial real estate.  REITs yield an income stream from the rents on the properties. This income stream, which is paid in the form of a dividend, is highly correlated with LIBOR. Dividends tend to rise as LIBOR rises.  Over the past six months, LIBOR has risen by approximately +80 basis points (0.8%) while REIT prices have fallen -6.2%.  The market value of all REITs is approximately $1T, whereas the market value of the S&P 500 index is approximately $25T.

Delinquencies on Consumer Debt Rising

Student, auto and credit card debt

Consumer debt has been growing at an average rate of 4.4% y/y since 2003, outpacing nominal GDP growth of about 4.0% y/y over the same period. This faster growth rate implies that the economy is now somewhat more exposed to consumer debt than before. Credit card debt has grown on average 1.3% y/y since 2003, auto loans have grown 4.0% annually, but student loan debt has soared at an annual rate of 12.9% from $0.25T to $1.4T in just 14 years. More to the point, despite the fact that the outstanding debts are similar in magnitude to student debt, the delinquency rate is something completely different.  Chart 5 a, b, c shows the amount of debt outstanding which is delinquent by 30 days. Clearly student debt is by far the worst performer with an 8% delinquency rate, resulting in $106B of delinquent debt outstanding. The credit card debt delinquency rate is only 2.5%, although it is worth noting that the amount of delinquent debt has risen sharply over the past four years from $16B to $20B. Auto loans have a delinquency rate of only 1%, but again have almost doubled in four years from $10B to $18B.   And while delinquencies are increasing in all three categories of consumer debt, they are all exposed to variations in short-term interest rates as well. Credit card rates are perhaps the most sensitive to LIBOR.  And as LIBOR has risen around 0.85% over the past year, credit card rates have used the excuse to skyrocket about 1.5% to almost 15.5%.

Chart 5 a, b, c: Consumer rates and LIBOR