Rising interest rates will impact agriculture
Business news media became very focused this past summer, on trying to determine when the Federal Reserve would begin to "taper" its Treasury-buying program tagged "Quantitative Easing", designed to reduce long-term interest rates and stimulate business borrowing and economic activity during the recession. Simultaneously, investors, whom had been purchasing Treasuries as a safe-haven, obviously not just for the yield, began to change their outlook. Owners and former buyers of U.S. Treasuries apparently changed their expectations for further price increases and started selling long-term treasuries more aggressively and interest rates increased. So investors, or "the market", seemed to be anticipating interest rate increases before the Federal Reserve has actually changed anything. Are investors jumping the gun? Maybe. As investors have aggressively bid up Treasuries for perceived safety of principal in recent years, they could experience losses if their Treasuries were purchased towards the end of the price increase trend (interest rate decline). As of now, interest rates have begun to increase as Treasury prices have decreased.
So, if we are at a point where interest rates are beginning to increase after 30 plus years of decline, what will it mean to agriculture and your farming operation? Probably many things and hopefully adjustments occur incrementally and not suddenly. Slower changes would allow gradual adjustments and adaptation by business decision-makers.
Interest Expense as a percentage of Gross Farm Income
Interest Expense as a percentage of Gross Farm Income has steadily declined from 5.8 to 1.8 percent for the average farm in data from the Southwest Minnesota Farm Business Management Association and FINBIN at the Center for Farm Financial Management at the University of Minnesota. The Farm Financial Standards Task Force recommends that a ratio at 5 percent or below is strong while a ratio of 10 percent or above causes a farming business to be financially vulnerable. This trend is true for the average profit farm, the high profit top 20% of farms and the lower profit 20% of farms. The levels vary but, the trend has been clear. This is due to not only declining interest rates on loans but, also a decreased use of operating loans and intermediate term loans for machinery and equipment. With historically strong Net Farm Incomes in recent years, many producers have reduced their use of short and intermediate term loans.
So far in 2013, with crop costs of production at record levels and fall/new crop prices at or below the expected break-even costs, it appears this trend could reverse. This of course depends on how this growing season progresses. If Gross Farm Incomes decrease at the same time that interest rates begin to increase there will definitely be upward pressure on the ratio of interest expense as a portion of Gross Farm Income for the typical farm.
Borrowing expenses will increase and will need to be more closely evaluated and monitored. Judicious use of borrowed funds is historically necessary for business expansion and growth. In efficient operations targeted use of borrowed funds or leverage, increases rates of returns on assets and equity. Over use of "leverage" or borrowed funds not only increases financial risks but also will increase interest rate expense especially in an increasing rate environment. Benchmarking key measures such as interest expenditures can help a farm business manager balance the use of credit in their operation.
The opportunity cost of money
Rates of return from farming operations have remained at historical highs for the last 5-7 years. The profit margins for crop production have been hard to match, especially during a recession for the remainder of the U.S. economy. There were few comparable rates of returns offered in savings or in many non-farm investments. This fueled much investment in not only agricultural production but also in farmland. Lease rates were bid up dramatically as well as purchase prices of land.
Now, with expectations for lower prices this fall and into 2014, coupled with increased production costs, potential profits and rates of return are projected to be less positive. If this situation becomes reality, higher interest rates on non-farm investments and in other businesses may start to compete again with rates of return from investments in agriculture and farmland. If this occurs, hopefully it develops slowly and at the current lower debt levels of farms, will not be a dramatic shock. Optimistically, farm assets such as land, machinery and equipment prices will just be bid up less aggressively and hopefully will not experience a significant decline. Buyers and sellers will likely evaluate sales and purchases more carefully in a tighter profit margin environment especially with non-farm investments offering improving rates of returns. Agriculture would experience more competition for money than it has over the last 5-7 years. For the individual farm, careful enterprise budgeting will be important with each cost category requiring scrutiny for its impact on the bottom line. Success will be the result of doing well in several categories, not just one or two as judged against benchmarks of peer farming operations.
Several farming operations are well positioned to be resilient through tighter profit margin periods of time and increasing interest rates. Some experts do not expect interest rates to rise as dramatically as was the case the late 1970's and early 80's. Policy-makers will likely want interest rates to stay "in line" with but, probably 1.5-2% above inflation for the long-term. However, a rise of even 2-3 % in interest rates over the next few years would feel dramatic after so many years of declining rates. Time will tell if this is the turning point. As always, be prepared for more than just one scenario.