Taking Away the Punch Bowl: What Happens to Silicon Valley When the Fed Raises the Interest Rate?

September 18, 2015

Cover Photo Credits

The Federal Open Market Committee wrapped up its two-day September meeting yesterday, announcing that it would once again not increase the federal funds rate, most commonly and monolithically termed “the interest rate.” The federal interest rate is the rate at which banks, credit unions, and other depository institutions can trade funds with one another. When one bank has surplus funds, and another bank needs these funds, the Fed’s interest rate is the target interest rate at which these two banks should lend to one another. The Fed achieves this target rate by controlling the amount of currency in the economy. If it wants to lower the interest rate, it buys government securities and adds this cash to the economy; if it wants to lower the interest rate, it sells government securities and removes these proceeds from the U.S. economy.

Since December 16, 2008, the federal funds interest rate has been effectively zero—between 0 and 25 basis points (0.0-0.25%)—in response to the global recession caused by the subprime mortgage crisis and subsequent collapse of collateralized debt obligations issued by the largest banks. Seven years on, however, the noise surrounding whether the Fed should increase this rate, and what it effects will be, is deafening. The majority of this focus has targeted the impact on banks and depository institutions, government debt, and fixed-income accounts. But one of the less discussed areas that will surely be impacted, and which drives large portions of the economy, is Silicon Valley.

The tech sector is not only a huge driver of growth for the economy, but a focal point for presidential candidates. More importantly, the Fed’s rate has remained low for such a long period of time that almost none of today’s strongest tech startups—Uber, Airbnb, Snapchat—even existed the last time there was an effective interest rate higher than zero. Rather, much of the current “culture” of Silicon Valley arose in an era where money has seemed free. Despite not yet turning a profit, Uber doubled its valuation this past year, from $20 billion to $50 billion. Brad Brooks, writing for Bloomberg, says it is time for the Fed to “take away the punch bowl,” which risks exposing Silicon Valley to a sudden, precipitous drop in investment and venture capital—and leaving developers high and dry.

The principal reason this investment and venture capital could dry up is that tech investment has been one of the strongest places to put money these past seven years. Y Combinator President Sam Altman explains that Silicon Valley valuations are so high because the money has nowhere else to go:

“[W]e have this very bad policy, in my opinion, of zero percent real rates. There is nowhere to put capital. There is very little growth anywhere in the economy. And so, what you have is people seeing these startups, that are growing incredibly quickly, and [are] this very low-risk investment. If you put half a billion dollars into a $10 billion company, you get your money out first. As long as the company does not go down 21 times in value at the time of acquisition or IPO, you’re going to get your money back…. And maybe you get a return, because it’s really fast-growing. What we’re seeing with the late-stage valuations is a lack of places to deploy capital. [W]hen the interest rates come back, I fully expect valuations will go down.”

These valuations are the bread and butter of today’s startups. Meanwhile, fixed-income securities, where the borrower must make payments on a fixed schedule, are the opposite of equity securities like tech investments, which do not require companies to deliver a dividend. The return on fixed-income securities traditionally rises when interest rates do, increasing their attractiveness to investors. This happens at the same time that the cost of borrowing money goes up with the interest rate. This is the needle to pop the balloon: at the same time that it becomes more expensive for startups to borrow money, the yield for alternative investments goes up. Finally, as consumers face a credit crunch, they are less likely to invest in the smartwatches or tablets necessary to take advantage of this tech.

Venture capitalists disagree as to the effect this will have on the Valley, either in the short or medium term. Many predict that companies on the fringes will fail outright, as well as those that are not able to get their burn rates—the rate at which they spend cash to make a profit—under control. Unfortunately, these rates are currently skyrocketing. Bill Gurley of Benchmark, the respected VC firm, famously predicted “dead unicorns,” startups with a valuation of $1 billion or more, in the wake of an interest rate hike. For his part, Marc Andreessen, eponymous partner of the firm Andreessen Horowitz, thinks talk of a bubble is overblown, and that people merely “want” to think the Valley is sitting on a bubble.

While the Fed ultimately decided not to raise the interest rate at its September meeting, Fed Chair Janet Yellen has insisted all year, as she did yesterday, that the Fed would raise the rate before the end of the year. Altman’s words should probably ring in the ears of both private capital investors and startups. Without bracing for its effects, the Valley could look different after the cost of lending goes up.