The worst may be yet to come for interest-sensitive sectors

Hi, I’m Adam Slater, Lead Economist at Oxford Economics. In the past week, our research has focused on the recent behavior of, and prospects for, interest rate-sensitive elements of GDP. In our view, the relative resilience of G7 output in the face of aggressive rate hikes is partly due to the surprising strength in interest-sensitive parts of GDP. These are volatile sectors that contribute a lot to downturns and recessions.

In past cycles, interest rate rises had the biggest impact on GDP items such as residential investment, durable goods consumption and equipment investment. The impact came through fastest in residential investment and peaked eight to 10 quarters from the first hike.

Now, this time around, while interest-sensitive spending in the US initially followed a similar trend to past cycles, it has subsequently done much better. After five quarters, it was only 1% lower than its peak level versus an average of 9% lower in previous cycles. Residential investment has dropped sharply, but durable goods consumption and equipment investment have held up well.

So, what’s going on? Well, we think some elements of interest-sensitive spending have been boosted by fiscal factors and catch-up after the pandemic.

But probably more important have been two other factors.

First, the limited weakening of asset prices so far in response to rate hikes has supported consumption and investment by preserving wealth and collateral. And second, there’s been a rise in fixed rate borrowing by firms and households. We can see this in a much slower rise in interest costs than in the last rate cycle, especially in the US.

So, it looks like structural changes have lengthened the transmission process from higher rates to lower spending. And, they may have reduced the eventual impact, too, by making more of spending sensitive to long-term rates, which tend to rise more slowly.

But this doesn’t mean they won’t ultimately be a big impact from rate hikes on interest-sensitive spending. If we look back to the last rate hike cycle in 2004-2008, it took quite a while for the big negative effects on asset prices to come through, and similarly the main negative impacts on interest-sensitive spending were delayed compared to earlier cycles.

Indeed, on the basis of the last cycle, we’d only expect to see these bigger effects on spending 2-3 quarters from now. So, on this basis, it looks likely that further weakness in interest-sensitive spending lies ahead, and some leading indicators for equipment investment and residential investment are indeed pointing in this direction.