Jim Hartlieb:

Hello and welcome. My name is Jim Hartlieb, President of First Business Bank. This morning, we're going to talk about the rising interest rates as well as other macroeconomic data. I'm joined this morning with Bill Uelmen, President of First Business Bank Consulting, Senior Vice President Nancy Johnshoy of our private wealth group and Kevin Kane, President of our Southeast Wisconsin region. Good morning, Bill, Nancy and Kevin.

Nancy Johnshoy:

Good morning.

Jim Hartlieb:

Why don't we start Bill, if you don't mind, kind of set the table for us. There's been a lot of action in the interest rate environment over the last several months. Maybe talk about what's gone on and what we can look forward to over the coming months.

Bill Uelmen:

Sure. So the Fed has really been hocus since the beginning of the year, meaning that they're looking to raise interest rates, reduce the size of the balance sheet, essentially trying to take liquidity out of the market so that they can control and reduce the level of inflation that's hitting the market here in 2022. Most recently at the end of July, the Fed did raise interest rates, the federal funds rate by 75 basis points. It's the second consecutive 75 basis point increase that the Fed has done. The fed funds rate, the upper bound rate now is two and a half percent, and prime at five and a half percent. So it's been a very aggressive Fed trying to combat inflation. And we've seen that overall in interest rate markets. The markets are really trying to predict where the Fed is going to be in the future and how far they're going to raise interest rates to combat inflation.

Bill Uelmen:

So it does take roughly six to 12 months for the markets and the economy really to feel the effects of rate increases. So the Fed now has been raising interest rates from essentially zero to two point half percent. They have noted in the second quarter that spending and production has softened somewhat. So it has been a welcome result essentially from the Fed. However, inflation still is running very hot, and job gains in growth is still very, very strong. So they're really trying to get back to their 2% inflation bandaid, which again is far away from that at this point. We're sitting at eight to 9% inflation currently.

Bill Uelmen:

And in the last meeting, I guess we're looking, again the market is trying to predict where interest rates are going. So the Fed did state that they feel that level at two and a half percent Fed funds is neutral. And we know that the Fed is going to probably go a little further than neutral because they really want to and have a very strong mandate to bring inflation back to 2%. So we're looking at more rate increases most likely through the end of the year.

Jim Hartlieb:

Great. Thank you for the background on kind of where we're at and a little bit about what we're looking forward to. Nancy, with your focus on the equity markets and the economy, maybe your vantage point on how did we get here? What is the key metric or metrics that have caused us to need to increase rates like we have over the last several months?

Nancy Johnshoy:

Bill said the word, inflation is the key focus right now of the Federal reserve and investors. And so the Fed is, as Bill said, raising rates, trying to cool things down, and they're really just trying to bring demand down to a level that more closely matches supply.

Nancy Johnshoy:

So for the markets, for the equity markets in particular, higher interest rates can be a little bit of a headwind, especially for growth stocks. This low, highly accommodative environment that we've been in for a long time has been great for a lot of equities. But fact is, I mean, even though we have seen some slowing in the economy and some evidence that certain areas of the economy are slowing down, earnings are still strong. The job market is still very, very strong. Manufacturing is cooled off a little bit, but it's still in expansionary territory. So while inflation is the key issue, really it's a matter of whether or not the Federal reserve is able to engineer that soft landing. Can they slow things down without putting the economy into a recession?

Jim Hartlieb:

Yeah. Soft landing is a term we hear a lot of recently and they have their work cut out for them with all the other macroeconomic situations. The Ukrainian war, the pandemic, the supply chain issues that we're all dealing with as well. So it'll be interesting to see how this plays out, but Kevin, as you are out talking to clients and prospects, how do you see this affecting business owners and their decision making?

Kevin Kane:

Sure. And it builds off of some of Nancy's comments in the sense that the overall feeling among clients that we're talking to and prospective clients is generally positive with now maybe a little bit more reflection on the obvious change in rates. What does that mean for borrowing costs? So to the extent that there's been this theme of, okay, the job market's quite tight, do we put more investment into automation, for example? What does that return look like? So increased borrowing costs causing a little bit more reflection and thought around, how does that influence decisions to finance certain projects? Things like that.

Kevin Kane:

One other thing we're hearing a little bit about as well is in previous months, last year, and coming into this year, concerns about supply chain. There were moments when some of our clients might have been acquiring a little more inventory than they might normally carry as kind of a safety or a buffer. But now reflecting on that, and if there is a little bit of a softening of demand, do we try to work through some of that inventory and bring levels down a little bit?

Kevin Kane:

So those are a couple themes that we're definitely hearing about Jim. And then the last thing is, many companies still are quite liquid. So a little more thought than previous in terms of, okay, in a rising rate environment, do we have the right strategy for that liquidity in a zero or low rate environment? Questions about how to deploy that cash seem less important, but now are becoming more important because there's an improvement in return potentially around those kind of choices.

Jim Hartlieb:

Definitely a challenging environment for business owners as they tackle the labor market at the same time with all these other economic issues. So Bill, back to you, as we look forward, the next Fed meeting, you can talk about when that is, but maybe a little foreshadowing of what the market is telling us will happen with rates over the coming months into 2023.

Bill Uelmen:

Sure. So when you look at the treasury market right now, the curve is actually inverted. So I mentioned Fed funds is at two and a half percent currently. The two year is trading right around 290 level, and the 10 year at about a 260. There's about a 30 basis point inversion built into the market. So what that's telling us is the bond market feels that long term, the Fed will have to lower interest rates because the economy will start to slow. And so we're seeing that. It's a very strong predictable recession indicator is inverted treasury curve. And we'll see very likely Fed funds trade up to three and a quarter, three and a half something in that level, and the 10 year being less than that for quite some time. So that inversion is a strong indicator that we anticipate.

Bill Uelmen:

And the Fed does have additional meetings coming up. The quarterly meeting is, the next one is September 21st. So it is about seven week difference between the last meeting which we had at the end of July. And there's a lot of information coming out. And one of the things that the Fed, that chair Powell said, is that the Fed is going to be very data dependent. So a little less transparent on what they're planning on doing, but between the meetings, we're going to see two inflation prints come out, we're going to see three different employment reports come out. And then the Jackson Hole Symposium, which is where all the world central bankers get together and talk about policy and economy.

Bill Uelmen:

So a lot is happening over the next six weeks. That really will determine what the Fed will do through the end of the year. But they're very outspoken that their plan is to bring inflation back down to the 2% level. So that does mean higher short term rates. Yeah.

Jim Hartlieb:

So seven weeks seems like a long time, Bill. Is that the normal cycle? And would they ever consider an emergency meeting if inflation spirals out of control?

Bill Uelmen:

Right? It is normal usually about every six weeks is when the Fed meets. So however the calendar worked out, it turned out to be seven weeks this time. And the market somewhat was calling for interim meeting rate increase. So when the June inflation numbers came out, the market really anticipated the Fed doing a bigger interest rate hike in July. And I think with under chair Powell's control, they've been very transparent. And they've been really not trying to spook the markets in between meetings. So I don't think they'll do anything in between meetings unless something really drastic happens in the economy.

Jim Hartlieb:

With that backdrop and Nancy, as you're talking to investment clients, interest rates continue to rise and all the other things we've talked about, how are your conversations going? What are the themes of your meetings with clients and how would you advise them to look at the market as we look forward here?

Nancy Johnshoy:

It's been a rough year in 2022 for investors. I mean, not only have we seen volatility in the equity markets, which we're a little more used to, but we've also seen a good deal of volatility in the bond market. So the portion of your portfolio that traditionally has provided a little backstop for the risk and volatility of the equity component has also provided a fair bit of volatility and negativity this year.

Nancy Johnshoy:

So it's been a rough year. I think investors, our clients are investors. They're not traders. So when we're having conversations with clients, we're talking about the long term, we're talking about what is probably going to unfold over the next couple of years and not the next couple days or the next couple of weeks. So as you're watching television and you're hearing, are we in a recession and what's happening, is the Fed going to do this? Or are they going to do that? It's going to be 50 or a hundred or 75. We're certainly very tuned into that, Jim, but it doesn't drive our day to day decisions the same way our long term outlook does.

Jim Hartlieb:

So that's the investment perspective. Kevin, as we think about business owners and we're in this weird time where two years out long term fixed rates are supposed to be a half percent less. So if I'm looking at a capital investment and possibly a loan with that, what is that telling me? And how would you advise business owners that are looking at those types of situations?

Kevin Kane:

Sure. Well, I think this conversation that we're having is kind of representative of what business owners deserve and what they're looking for. Which is, as things become more uncertain, do you have trusted advisors that are going to be there for you to test some of your thinking? If you're a business owner, you're evaluating the possibility of embarking on an expansion or investing in a new development, those kind of things. So I think one of the keys is those trusted advisors. It could be your banker, your accountant, your attorney. And making sure that you are getting their perspective, which is broader. And just by virtue of talking to a lot of companies, that's our experience as bankers. So we're able to validate perhaps some of their thinking, provide unvarnished advice around okay, have you thought about, or considered this aspect of things?

Kevin Kane:

And rates in particular, it's true that in the last six plus months, the rate environment has changed. Don't want to lose sight of the fact that relatively speaking in terms of history, even where rates are at right now are still pretty attractive overall. So not to lose sight of that longer term perspective, which again is something we can offer. Because it's our job to understand where rates are going and how that compares to where they might have been in the past. So those are just a few thoughts, Jim, on advice on that front.

Kevin Kane:

And then the last thing I would say is when we talk about some of the other solutions we have around cash management services, just to be mindful of, is it time to take a look at the tools that your banker can bring to help you manage your cash effectively. And some solutions that might help you in terms of your back office and how to optimize working capital, minimize borrowing expense where possible, make some improvements into your process?

Jim Hartlieb:

I think that's a great perspective to bring on interest rates in general. The 40 year average for that five year fixed rate is still mid fives to almost 6%. We've been a little brainwashed over the last few years that we start thinking 3% is the new normal. And it's just not, historically speaking at least. And so can you make that project make sense at more normalized rates, is part of that conversation.

Jim Hartlieb:

I want to go back to the I word, not to put you on the spot Bill, but has inflation, has it peaked? It's at a 40 year high? Do you think it's peaked?

Bill Uelmen:

That's a good question. I think the market thinks it has, right? So you look at how the bond market has rallied, how equities have recovered here in the short term, it may have peaked. It's really hard to say. And that's even what chair Powell is saying, that we just don't know yet, but we're trying to combat that as hard as we can. We have seen growth numbers come in. We did see manufacturing numbers come out yesterday and the inflation component of those numbers was down. So we have seen some relief, at least initially on the inflation side.

Bill Uelmen:

The consumer still is spending. So there is some resilience still in the consumer market. The services sector is really starting to pick up. So initially the manufacturing sector really started to grow and that's where we built up inventories and inflation started to hit and trying to refill the supply chain. Now the services sector is. Travel has really increased significantly and the consumer seems to be spending their excess liquidity and not saving. And that is a sign that inflation probably will persist for a while. They may have peaked, but I think we'll still have inflation through the end of the year and leading into 2023.

Jim Hartlieb:

Appreciate that perspective. And Nancy, as you look at the inverted yield curve, is that a predictor for us as we look to what could happen next when we've seen the two year higher than the 10 year? What does that tell us about what might happen in the future or what will happen given historical standards?

Nancy Johnshoy:

Well, an inverted yield curve has been a pretty reliable indicator of a recession. I think the last 10 recessions were preceded on average 14 months by a inverted yield curve. It has inverted a few times, I think, without a meaningful recession. And I think that's a topic too is, we've seen two quarters now of negative GDP. And a lot of people are talking about the fact that's kind of a technical definition of a recession. But I guess I would say, it doesn't to me really feel like a recession at this point in time.

Nancy Johnshoy:

Job market's very strong. We did see job openings come down just a little bit, but there's still almost two jobs open for every person looking. So that's a very strong job market. We are seeing still strengths in earnings. Manufacturing is still in expansionary territory. So to me it may fit the technical definition of a recession, but I don't know that to me, that it really feels like a recession at this point in time. Things are still pretty strong. And as Bill said, pretty positive momentum.

Jim Hartlieb:

Yeah, you're right. If it is a recession, it's a very odd one because it doesn't feel like it with demand as high as it is in a number of different categories. As we look to wrap up here and thinking about business owners out there that are listening to this podcast, maybe some advice. If you have one or two things that you've seen a successful business owner do or something that you yourself have done as we've faced these situations in the past. And I guess I'll go back to the top. Bill from your perspective, any advice you'd pass along?

Bill Uelmen:

Well, I guess of course don't panic. The Fed is going to raise interest rates. We think they're getting closer to the terminal rate, meaning the peak will raise interest rates, but they could go beyond that. They very well could go to 4% on Fed funds, which would then raise the entire curve. But the Fed is going to do their best to control inflation. And it will eventually come down. And one of the outcomes most likely will be, we'll see some layoffs. We'll see some further recession signs such as unemployment increasing, but overall I think we have a pretty solid base. So really not to panic seeing these higher rates, because as you mentioned, the base rate is still historically at that 40 year historical level. And I think the economy should be able to support the higher rates.

Jim Hartlieb:

Nancy, any thoughts?

Nancy Johnshoy:

I would say that I think when we're looking back on this point in time. When we're a year down the road, two years down the road, five years down the road, we're going to look back on this as a great opportunity to put some money to work. We can finally get a better yield on our fixed income investments. So if you do have cash and liquidity, finally earning a little bit of interest on that, which we haven't seen in the last couple of years. And the equity markets. I mean this pullback in equity valuations and prices really makes an attractive entry point and I'm not trying to call a bottom, but I think as you're again, looking back with some distance time-wise from this event, you'll say yeah, it was a good time to put money in.

Jim Hartlieb:

Excellent advice. Kevin, any final thoughts?

Kevin Kane:

Sure. I think one thing that Bill just described, don't panic. And I do think that over the last couple years, for a variety of reasons, many companies have de-levered. There's a fair amount of liquidity. So that's a really good foundation. And I would say, have a plan maybe. And it's no different that should never not be part of a business owner, an executive's thought process. So have a plan, but also think in terms of contingencies if certain external conditions go in a certain direction. But stick with the fundamentals, have a plan.

Kevin Kane:

And the final thing I touched on it earlier is stay close to your trusted advisors, lean on them. That's what we're here for. Consider us as part of your team. And we're here to support you, provide perspective and information so that you make the best possible decisions.

Jim Hartlieb:

Yeah, that's great. I would just add, in my career, the business owners that seem to be the most successful have a great blend of letting the data drive them, but using their gut feel. They're in it every day, it's their life. And so being able to use that gut feel along with the data, I think will lead to really good decisions. And like Nancy said, taking advantage of opportunities when others might be shrinking a bit in their aggressiveness.

Jim Hartlieb:

Thank you Bill, Nancy and Kevin, for your insights. To our listeners, if you would like additional resources or have other questions, please visit firstbusiness.bank. Thanks again for listening. Have a great day.