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Rising Interest Rates and the Importance of Credit Risk

By Karl Kimball, Aston Carter Executive Advisor, Governance, Risk & Compliance

What Is Happening in U.S. Financial Markets?

Consumers and businesses across the U.S. are feeling the financial pain of high inflation. From gasoline and energy to groceries and rent, Americans are paying more for everyday necessities as the value of the U.S. dollar weakens.

Inflation — defined as a broad increase in the price of goods and services — reached a 40-year high in June 2022. Despite 45% of U.S. workers receiving a raise in the past year, more than half say that their income is not keeping pace with rising inflation.

In addition to inflationary pressures, companies face continued supply chain disruptions and increased operating costs. While some have absorbed these added costs, others have been forced to increase prices to stay afloat. According to the National Federation of Independent Businesses, 86% of small businesses in the U.S. report raising prices due to higher costs for energy and gas, materials, rent and labor. From rising interest rates and increased credit risk to mounting fears of an economic recession — inflation is causing ripple effects throughout U.S. financial markets.

What Is Causing High Inflation?

The Federal Reserve — America’s central bank — is responsible for the operation and stability of the U.S. economy, including the nation’s monetary policy. When U.S. financial markets are struggling, the Federal Reserve can inject new money into the economy. This emergency measure can include the purchase of government securities and bonds, which increases the U.S. money supply.

Amid the COVID-19 pandemic, the U.S. government appropriated trillions of dollars through the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the American Rescue Plan Act and other federal legislation to provide relief to Americans and stimulate the economy. Between 2020 and 2022, Federal Reserve assets more than doubled — increasing from $4.1 trillion to nearly $9 trillion. This rapid growth of the U.S. money supply paired with a lagging economy triggered a rise in inflation.

How Is the U.S. Government Responding?

U.S. congressional leaders, the Biden Administration and the Federal Reserve are taking steps to fight high inflation through a combination of legislative action and monetary policy maneuvers. Government leaders are making significant investments in domestic energy production and manufacturing, implementing a historic down payment on deficit reduction and using the nation’s monetary policy tools to slow economic growth. With fears of an economic recession looming, the U.S. government — particularly the Federal Reserve — is attempting to engineer a soft landing for American consumers and businesses alike.

Increased Tax Enforcement

President Biden recently signed the Inflation Reduction Act of 2022 in an effort to curb high inflation. The Act, which includes a broad range of provisions, allocates $80 billion in supplemental funding over a 10-year period to the Internal Revenue Service (IRS). These funds are intended to modernize the agency and increase federal tax revenue by reducing unpaid taxes and preventing tax evasion.

Approximately $45.6 billion of total funding is earmarked for enforcement activities — including the hiring of enforcement agents, legal support and investments in investigative technologies. The funds are also expected to be used for monitoring and tax enforcement on growing digital assets such as cryptocurrency. Through these measures, the U.S. Congressional Budget Office predicts that IRS revenues will increase by $204 billion through fiscal year 2031.

Interest Rate Hikes

Interest rate hikes are the U.S. government’s primary policy tool to mitigate inflation. Simply put, raising interest rates makes money more expensive to borrow — reducing consumer spending and business investment.

The Federal Reserve raised interest rates six times in 2022, including four consecutive hikes at three-quarters of a point. As a result, the central bank’s new lending rate rose to a range of 3.75%–4% — the highest target since 2008. Rates are expected to increase into 2023, with some experts projecting rates as high as 5%. Small to mid-size companies — many of which rely on floating or variable rate financing — are most likely to bear the brunt of higher interest rates and reduced consumer demand.

What Are the Effects of Increased Interest Rates?

Rising interest rates add stress to struggling financial markets, increasing risk for borrowers and lenders. Higher prices can force consumers and businesses to cut spending, rethink investments or increase reliance on credit. Mortgage loans and corporate bonds are among the types of financing directly impacted by higher interest rates.

Soaring Mortgage Rates

While the Federal Reserve does not set mortgage rates, short-term interest rate changes influence the prime rate for mortgage lending. U.S. homebuyers are now facing the highest mortgage rates in 15 years — forcing many potential buyers to drop out of the market. The average interest rate for a 30-year fixed loan has more than doubled, making purchasing a home today significantly more expensive than just one year ago. Those who purchase real estate now face higher monthly mortgage payments due to higher interest rates.

Increased Credit Risk for Corporate Bonds

While corporate bonds provide companies with critical funding, they also pose an increased credit risk when interest rates rise. Investors who buy corporate bonds lend money to the company issuing the bond. In turn, the company is legally obligated to pay interest on the principal of the loan and return the principal amount when the bond is either due or matures.

Companies that have issued bonds and need to roll them over will do so at a significantly higher cost. Higher interest rates can make the rollover unattainable for some companies as bond prices — the cost to service the debt — become unaffordable. If the bond or issuing company poses a high risk for default, credit rating agencies may decrease their credit rating.

The Risks of Slowing the Economy

While periods of economic contraction are normal, a lagging economy can shift to a recession — a significant period of economic decline lasting months or years. Generally, two consecutive quarters of declining gross domestic product (GDP) indicate a recession. In addition to this economic threat, there are other serious risks associated with slowing the economy.

A Weakened Job Market

The Federal Reserve’s attempt to cool the economy poses significant challenges in the labor market. Despite a booming job market and low unemployment, slowing the economy can hinder profits, investment and growth — resulting in reduced hiring and potential layoffs.

The Federal Reserve predicts that the U.S. unemployment rate will hit 4.4%, leaving 1.2 million Americans unemployed. Additional projections show that a 5% unemployment rate is possible and would leave 2.2 million Americans without jobs.

Reduced Consumer Spending

Economic uncertainty can trigger changes in consumer demand and spending. As borrowing money becomes more expensive, consumer purchases typically trend downward. While household spending in the U.S. increased 0.4% in August 2022, it may be attributed to a drop in gas prices and consumer reliance on credit cards or savings.

Stock Market Volatility

The Federal Reserve’s aggressive approach to taming inflation in the U.S. has sparked increased uncertainty among investors. With additional interest rate increases expected this year, volatility in the U.S. stock market is likely to persist.

Financial Risks Facing Businesses

High inflation, increasing interest rates and a lagging economy can increase a company’s risk for defaulting on payments or facing bankruptcy. It is essential that companies understand, assess and mitigate financial risks — specifically credit risk, market risk and liquidity risk.

Credit Risk

Similar to consumers, companies also receive a credit score. A company’s credit rating is a key indicator in determining the risk of doing business with them. The credit rating reflects the likelihood of a company meeting or defaulting on debt obligations and is a key indicator for deciding if and how to engage in business relationships.

Market Risk

Companies are affected by factors that influence the performance of financial markets, such as changes in prices and rising interest rates. Soaring energy prices and ongoing supply chain disruptions are examples of market factors that are challenging businesses at home and abroad. Companies must consider how to continue production amid unstable market factors while servicing their debt obligations.

Liquidity Risk

Liquidity risk is the risk in an organization’s ability to meet debt obligations or survive adverse market conditions. Companies rely on models to project potential losses and must set aside reserves — similar to a savings account — to navigate challenging environments and losses.

What Can Businesses Do?

Companies should utilize risk management processes, experts and tools to evaluate evolving financial markets. Investing in high-quality data collection, forecast models and analytics can better position businesses to make strategic decisions about key factors like:

  • Which assets to hold versus sell
  • Whom to conduct business with based on risk and benefit
  • How much cash to set aside versus return to shareholders or invest
  • When to pivot back to growth before competitors 
 

Recruiting and retaining knowledgeable professionals skilled in credit risk, market risk and liquidity risk is essential to navigating financial risk in any industry. So, as the demand for financial managers, financial analysts and similar professions increases, companies must be equipped to compete for top talent.

How Talent Solutions and Managed Services Can Support Financial Risk Management

Partnering with a leading staffing and consulting firm can help organizations strategically manage and mitigate financial risk. Access to a network of top talent, expertise in risk management processes and innovative thought leadership are among the advantages of working with a trusted partner like Aston Carter.

Managed solutions teams can support all aspects of financial risk management, including data collection and transformation, model building and quantitative analysis as well as data analysis and reporting. Depending on corporate needs and goals, Aston Carter can deliver individual risk management experts or a team of knowledgeable professionals to fulfill the requirements of your specific project. Our team of expert advisors are also available to consult on specific risk areas, financial products and data as well as leading risk management tools.

Contact Aston Carter for more information on how our strategic solutions can mitigate financial risk.

Karl Kimball is an executive advisor for Aston Carter’s governance, risk and compliance (GRC) offering. His journey at Allegis Group began in 2016, serving as an executive advisor before joining Aston Carter in 2020. With 22 years of experience in the financial services industry — 10 where he served as senior vice president at Bank of America — Karl has worked alongside industry leaders, launching new offerings and strategizing new business opportunities.