What Happens to Self-Funding Early Pay Programs When the Fed Raises Rates? Part I David Gustin - July 14, 2015 4:32 AM | Categories: Payables Finance, Trade Credit Commentary | Tags: rising interest rates Federal Reserve Bank of Boston President Eric Rosengren recently commented that all but two on the Federal Open Market Committee felt raising rates sometime near the end of this year is necessary. He mentioned two conditions the committee has for raising rates: The continued improvement in labor markets Fed members are reasonably confident that inflation gets up to 2% So far the second condition is not being met, according to Rosengren. Basically, the Fed is leaving lots of room to hedge. Core Personal Consumption Expenditure (PCE) inflation is 1.2%, so the Fed needs more evidence. Maybe that evidence will be labor markets tightening and wages rising, but as we know, there is slack in the system, given many have dropped out of the labor force. Regardless, the Fed has made its intention on raising rates, and when that happens, the leverage in the system, even if rates go up 25bps, will have dramatic impacts on corporate balance sheets and possibly companies' ability to self-fund. Notice Rosengren is talking about raising rates, not selling the Fed's bond holdings – it owns more than 10% of the outstanding bond market – or normalizing interest rates. If the Fed raises by 25 bps, and is successful, that is effectively doubling interest rates on a relative basis. On absolute, its only 25bps, but a more leveraged company has more pain with that increase than a less leveraged one. If you are leveraged 7-to-1 as a Leveraged Buyout (LBO) company, that’s 150bps. When does it start changing behaviour? I don’t know, but any increase is meaningful given where we are today, and certainly starting out at near zero. So how does this impact early pay programs or as my old consulting bosses used to say, whats the so what? The so what is if you have $500M in cash as a company treasurer, and you are not investing in your business, meaning not investing in assets and inventory, you are doing all kinds of things to finesse your cash. Given the low growth economy we are in globally, a shareholder would want a dividend and return of their capital. If you are high growth, it’s a different story. You can invest in your business. Look at corporate M&A. It’s exploding. People have to justify cash and if we are in a slow growth world, you need to buy growth. Even if the Fed raises the Federal Funds rate, that just means it's charging banks more money. We don’t know if it works its way into higher rates in the economy. But if it does, we all need to look at this in the absolute and relative context. Companies have been borrowing very cheaply for a long time. (Forget about government – that’s a scary issue and probably a true bubble story). There is leverage in the system. How it will impact all the early pay initiatives is definitely something to keep an eye on. Tomorrow we will look at why raising rates is so tough do for the Fed. P.S. If you would like to receive TFM's weekly digest, sign up here. Related Articles Discuss this: Cancel reply Your email address will not be published. Required fields are marked *Comment Name * Email * Website Notify me of new posts by email.