When the Fed first hinted at winding down its quantitative easing (QE) program last May, headlines were convinced it signaled the death knell for the recovery—long-term interest rates would rise, loans would be more expensive, consumers would stop borrowing, and growth would stall. But here we are, nine months later, with the latest Fed data showing consumer borrowing rose for the second straight quarter in Q4 2013—and for the second quarter since before the financial crisis. The $241 billion rise was the biggest since Q3 2007, despite long-term interest rates finishing 2013 at their highest level since mid-2011. Rising rates, it would seem, are not economic kryptonite (Exhibit 1).
Exhibit 1: Household Debt and Long-Term Interest Rates
Source: Federal Reserve Bank of New York, Equifax and Federal Reserve Bank of St. Louis, as of 2/18/2014.
How did lending rise even though it became more expensive? Headlines credited “confidence” and resurgent demand. “Consumers are borrowing again,” went the common media meme. Yet, according to the Fed’s Senior Loan Officer Opinion Survey, this doesn’t square with reality. On balance, loan officers have reported rising demand since 2012’s outset. Folks have been plenty willing to borrow. Prime mortgage demand growth, too, has been strong—until Q3 and Q4 2013, when it leveled off some. It seems exceedingly difficult to argue the mythical animal spirits magically reappeared in Q3 and Q4.
What did change: Banks became more willing to lend. According to the same Fed survey, the number of banks tightening credit standards for consumer and mortgage lending fell over the same period.
It’s always dangerous to pin changes in supply or demand for a product on any one variable—and a variety of factors likely made banks more willing to lend in the second half of 2013, like banks’ own confidence in the sustainability of this expansion and, by extension borrowers’ ability to repay. But in our view, the rise in long-term interest rates likely played a sizeable role. As we’ve written before, long-term rates represent banks’ lending revenues. Falling rates means falling revenues—and when short-term rates (a proxy for banks’ costs) are pegged near zero, falling long-term rates also means falling profits. That’s a big incentive for banks to sit tight and lend to only the most creditworthy borrowers—and a big reason why lending fell while interest rates were ultra-low. Now that rates are higher, the higher potential profits encourage banks to lend to a much wider swath of customers. Some folks might find themselves qualifying for a loan for the first time in years.
This all ties back to the age old question: If you want to boost the sales of a product, do you try to boost the supply or the demand? In its quest to boost lending through quantitative easing, the Fed tried to boost demand. It probably succeeded. But higher demand didn’t translate to higher household lending, which tells you the supply side mattered more. Now that lending is more profitable, we’re finally starting to see supply increase, and household lending is finally rising.
In our view, this illustrates why QE was so misguided—and why investors should embrace, not fear, its end. Even if rates don’t rise much after the Fed stops buying bonds—and they may not, considering how efficiently markets priced in expectations for the end of QE last year—we should see further gains in lending from here. It takes time for monetary policy changes to show up in economic data. We’re only just now seeing an uptick in banks’ net interest margins, even though 10-year US Treasury rates—the reference rate for most long-term lending—have risen for about 18 months. This lag suggests net interest margins have plenty of room to rise just to catch up with the rise in Treasury yields.
You won’t read this many other places, however—most outlets continue focusing on demand, largely ignoring the supply side. As long as they do so, fear will persist, and the brightening reality of improving loan supply likely goes unnoticed. For stocks, this is bullish—it means there remains plenty of room for improving lending in a post-QE US to catch investors by surprise, pushing markets higher.
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