While the Fed plays a role in setting the benchmark for short-term interest rates, its policies also determine inflation expectations over the long-term. After keeping rates low to help the economy recover, the Fed are on a plan to slowly (hopefully) start raising rates, and today we are due for a new rate hike for sure.
What’s Going On Here?
An influential measure of US dollar borrowing costs has spiked sharply in recent weeks, causing concern among some investors – and potentially hiking interest payments for a huge number of companies (and individuals) around the world.
What Does This Mean?
Weirdly, a certain key short-term interest rate, Libor, has shot much higher than the US Federal Reserve’s target. That usually only happens when the financial system undergoes major stress, like during the 2008 financial crisis – which doesn’t seem to be the case today.
There are a number of less sinister reasons why Libor might be spiking, including the US government recently issuing lots of very short-term bonds (for which investors demand a higher interest rate, due to the larger supply and limited number of buyers). US companies with big overseas operations are also likely buying far fewer of these short-term bonds as they prepare to spend their recently repatriated profits on things like expanding their operations and/or paying a bigger dividend to shareholders.
Why Should I Care?
For markets: Borrowing costs have gone up – which tends to hurt profits and, ultimately, the economy.
Lots of people and companies borrow money on a “floating” basis, which means that their interest payments depend on a market-driven rate of interest. Since banks borrow lots of money at the Libor rate, it can push up the rates at which they lend to their customers. That means people and companies could end up spending more on interest payments – and less on other things (which is typically negative for the economy). And since US dollars are borrowed around the world, the impact is global.
For you personally: Budgeting for higher interest rates is probably a good idea.
While predicting the future path of interest rates is difficult, it’s eminently possible that the cost of borrowing money will get significantly higher in the coming years (e.g. your mortgage payments may go up noticeably). After almost a decade of ultra-low interest rates, this could come as a shock to many people’s budgets. Consider yourself warned!
It’s important to understand that higher rates also can have an impact on small businesses in three ways:
- Business planning
An increase in interest rates can likely have an impact on an owner’s ability to grow a business. When interest rates rise, banks charge more for business loans. While small business owners with fixed rate loans may not be affected immediately when interest rates rise, company owners with loans that have fluctuating interest rates may find their loans more difficult to repay. Higher loan payments may lead to a reduction in profitability, which can make securing future funding more difficult. Without these loans, businesses may be forced to rededicate their resources away from innovation and reinvestment.
- Cash flow
Small businesses tend to operate with limited cash flow, so when interest rates rise, the additional cash needed to repay loans can be scarce. In addition, short-term loans to cover cash flow gaps may be difficult to qualify for or too pricey to afford. This could cause a host of issues. Business owners may have to delay paying their receivables, or put off investment and expansion plans, which can further slow the growth of the company.
- Customer spending and saving
Changing customer spending habits triggered by rising interest rates may also reduce cash flow. When consumers have to pay higher interest on personal loans, including mortgages and auto loans, they have less disposable income to buy goods and services. In a rising rate environment, consumer-driven businesses often see a reduction in sales, further squeezing cash flow. In addition, higher interest rates make it more attractive for both consumers and businesses to save excess cash rather than spend it.
How About For startups?
Well, the same above three ways that impact businesses will also have a direct effect on startups overall. It’s going to be even harder to raise money as the interest rate hikes are going to impact the way angel and private investors look at the ROI of investing in startups. Investors are always looking for companies who have created sustainable business models, rather than those that have an idea but haven’t quite figured out how they’re going to grow and monetize it (Commercialize it). For mid-to-late stage startups with solid revenue models raising funds will not be as difficult as the new-comers. But still, companies that are looking for late-stage financing are often getting those funds from investors who are looking for a faster return on their cash. Those investors ultimately might move to investing elsewhere. Rate hikes will start to move investors’ allocation of resources very slowly away from higher-risk growth opportunities; subsequently lowering the cash available for start-up firms and toughening the conditions to get that cash.”
There are alternatives for startups such as taking on some form of debt financing introduces the concept of financial leverage to a business. If an owner can earn a return of 15% (or more) on a sale, and is paying 7% in interest, they net a return of 8% without having to dilute their equity or disrupt cash to ongoing operations, assuming customer payment timing lines up. When an owner has confidence that they’ll be able to achieve that return above costs of debt, it can be the best opportunity to take advantage of access to capital. When there is less confidence in that investment return, it is a good time to do more extensive financial/revenue modeling to determine whether the risk versus reward makes sense. It’s going to be the time for business owners need to be careful not to take on too much risk.