With a strengthening labor market and rising economic activity, the Federal Reserve has raised the Federal Funds Rate by a quarter point to support a thriving business and individual environment. The Federal Funds Rate currently sits within a range of 5.25% to 5.5%, with some expecting yet another interest rate hike before the end of the year. This eye-watering series of interest rate hikes has flowed through to the lending costs for everything, from mortgages to student loans and vehicles.
In the auto market, concerns around a potential crash are building. Interest rates are one reason, and we’ll get to that in a second. However, there are other factors creating concern for investors right now.
Let’s dive in.
1. Higher Interest Rates Are Affecting Demand
The Federal Reserve’s efforts to combat inflation through interest rate hikes are constraining the affordability of new and used vehicles. Americans are adjusting their buying preferences, choosing used cars over new ones and prioritizing repairs over replacements for their current vehicles.
The Fed, responsible for maintaining purchasing power, raised rates 11 times from February 2022 to July 2023. Though it paused in September, the benchmark rate stands at 5.25% to 5.5%. These rate hikes coincide with a tight car market, driven by supply-chain disruptions, pushing average new vehicle prices above $48,500 in May, per Kelley Blue Book.
Rising interest rates increase borrowing costs, significantly raising vehicle financing expenses compared to previous years. Since the beginning of 2022, average vehicle interest rates have been climbing, a consequence of the Federal Reserve’s efforts to combat inflation. Higher borrowing expenses not only discourage spending but also limit people’s ability to afford major purchases, contributing to an economic slowdown.
2. Auto Sales Are Declining
While auto loan rates have increased this year, it’s essential to consider the broader context. They are still significantly lower than they were a decade ago when the average rate ranged from an all-time high of 17.36% in late 1981 to an all-time low of 4% in late 2015. Over the past decade, rates have generally remained within the 4%-5.50% range, except for recent months.
At the start of 2023, automakers experienced varying sales performances due to supply chain issues, with General Motors (NYSE:GM) being a notable exception with a 2.5% gain. Most automakers, including Ford (NYSE:F), Hyundai (OTCMKTS:HYMTF), and Kia, reported single-digit declines. Toyota (NYSE:TM) saw a 9.6% decrease, while Stellantis (NYSE:STLA), Nissan (OTCMKTS:NSANY), and Honda (NYSE:HMC) faced double-digit drops of 13%, 25%, and 29.4%, respectively.
3. New and Luxury Sales Being Hit Hard
Auto-financing rates for new and used vehicles rose by 31 and 29 basis points, respectively, in Q1 compared to last year. This increased cost is pushing buyers toward used cars over new and luxury models. Higher interest rates and monthly payments may prompt consumers to forgo expensive add-ons and opt for more affordable options or smaller vehicles to lower their monthly expenses.
Higher rates and stricter credit criteria will lead to more lending limits in auto financing. This will increase costs for original equipment manufacturers (OEMs) in providing low-interest loans and for dealerships in acquiring and managing inventory, posing profit margin challenges. To counteract this, consumers are opting for longer loans, paying more interest.
The Federal Reserve’s inflation-fighting rate hikes limit vehicle affordability, causing Americans, especially those with credit scores below 620, to opt for used cars or vehicle repairs. These consecutive rate increases primarily benefit high-income, high-credit-score buyers, according to Cox Automotive Chief Economist Jonathan Smoke.
Final Thoughts
Used vehicle prices, linked to inflation, have surged since President Joe Biden’s administration attributed rising inflation to the market last year. Last month, the consumer price index increased by 0.4%, driven by housing, used vehicle and gasoline prices. These rising interest rates compound the issue of already high vehicle prices, caused by limited supplies of both new and used vehicles due to pandemic-related factory shutdowns and ongoing supply chain challenges since 2020.
Regardless of future rate actions by the Federal Reserve, vehicle prices are projected to stay high for years due to the time needed to replenish inventories and transition new vehicles into used ones. Until that changes, it’s hard to see a scenario in which the auto market strengthens.
On the date of publication, Chris MacDonald did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
