A tipping point is forcing the Fed’s hand, but not for the reason you’d expect.

While the central bank will meet to discuss rates later this month, it’s probably about finished hiking.

You might think progress on the inflation front is the reason.

After all, the Consumer Price Index (CPI) came in at 4% year-over-year in May. That’s down from the peak of 8.9% last June.

But inflation is still nearly double the Fed’s target, while core inflation (which strips out volatile food and energy prices) is higher still, at 5.3%.

As a reminder, in May, the Fed paused rate hikes for the first time since March of 2022. Here’s what Inside Wall Street editor Nomi Prins had to say about the Fed’s most recent decision:

After months of its aggressive campaign, the Fed is pivoting.

[It’s] watching how rising rates affect different sectors.

But it might already be too late. U.S. GDP growth is slowing. Bank and consumer debt are both really high.

And as the days go by, more banks are set to collapse.

So, why the sudden pause?

It’s because the Fed is finally getting what it wants… companies in distress. And as the days go by, companies grow increasingly vulnerable to financial trouble…

Manufacturing Distress

The Fed can’t directly control inflation.

It can’t influence things like supply chains, geopolitical events, and public health crises. These are all factors that sent prices soaring in the past couple of years.

Instead, the Fed can manufacture economic booms and busts to steer inflation. If deflation is a risk, then the Fed grows the economy to boost prices. And vice-versa when inflation is too hot like today.

Last May, as rate hikes were underway, Fed Chair Jerome Powell referred to the central bank’s methods as “famously blunt tools.”

Meaning, the Fed doesn’t have the tools for precision strikes. It can’t just single out one sector like the housing market or manufacturing firms.

All it can do is impact aggregate demand, or the broader economy across all areas. And one way the Fed’s monetary policy infiltrates the economy is by causing financial stress for businesses.

The most financially vulnerable companies feel the impact first. A higher interest rate means larger payments on debt… similar to a higher rate leading to bigger payments on your mortgage.

So highly indebted companies with poor balance sheets or those struggling to turn out a profit are the first to cry uncle.

Those companies are forced to do things like put off hiring new employees or fire existing ones. They cut back spending in order to stay afloat.

Eventually, the pain gets so bad that these companies go bankrupt. And there’s mounting evidence that more and more companies are teetering on the edge of collapse…

Approaching the Tipping Point

There’s an old saying that banks will lend you an umbrella when it’s sunny but ask for it back when it starts to rain.

And if the bank thinks a storm is coming, they become more selective about making loans.

Similar to a credit card company performing a credit check before giving you a card, banks perform due diligence before making new loans to businesses.

And banks stay away from vulnerable companies. These are the most likely to have trouble repaying loans as the Fed raises interest rates.

So it becomes a self-fulfilling prophecy. If banks are more reluctant to lend to firms in distress, that increases the odds that the firms go under.

In fact, the Fed tracks firms that are close to defaulting and bankruptcy. Right now, the figure stands at 37% of publicly traded companies. That’s the highest portion of distressed firms we’ve seen since the 2008 financial crisis.

And with the Fed raising interest rates at the fastest pace in four decades, researchers at the central bank suspect that the economic fallout will be greater than any previous episode since the late 1970s.

We’ve reached the tipping point with companies in distress. Now, it’s just a waiting game.

That doesn’t mean the economy is about to collapse tomorrow.

But it does mean you should watch for increasing defaults in the months ahead.

The most important thing you can do is avoid companies on shaky financial ground.

That means looking at how much debt a company might carry on its balance sheet. It also means you should pay attention to how much income the company generates relative to interest payments on debt.

Firms with too much debt and too little income will be the ones most susceptible to growing distress.

And the prospect of defaults also means you should stay away from banks that could face heavy losses on their loan portfolios. (For more details on how to stay ahead of bank failures, check out Nomi’s piece right here.)

Regards,

Clint Brewer
Analyst, Rogue Economics

P.S. The warning signs above are just the beginning.

In the days ahead, we can see more distressed companies default on their loans. That means losses for banks. In fact, banks have set aside $20 billion to cover expected losses on their loans.

That’s why my colleague Nomi Prins filmed a special video presentation to explain what’s about to happen next… and how you can position yourself ahead of what’s coming. It involves a little-known asset with the potential to deliver as much as 50x profits.

For more details, make sure you watch the video by clicking here.