Are Higher Interest Rates Holding Back Herd Rebuilding?

Cow herd rebuilding in the current cycle has yet to begin, and it appears that 2023 will be another year of net beef-cow herd liquidation. Any producer plans of heifer retention seem to be a far-off proposition facing a number of headwinds. Not the least of these is the added interest cost in the beef supply chain due to the higher interest rate environment of the past 20 months or so.

While it is easy to calculate the short-term impacts on the various producing segments (cow-calf, stocker, feedlots) from these added costs, it is harder to recognize the way these costs shift through the supply chain and get covered in the long term. And cattle producers throughout the supply chain should be factoring interest rate cost and risk into the majority of their business decisions.

Rising Rates and Risk

Recent Federal Reserve data on national non-real estate agriculture loan activity shows that the average effective interest rate had risen to 9% for new loans for stocker and feedlot cattle during Q3 2023 and was up to 7.5% for new loans in the “other” category, which includes breeding stock on cow-calf operations.

On top of the rise in interest rates, an increasing percentage of new loans have a floating, or variable, rate.

For stocker and feedlot cattle, this was a 4% increase compared with a year earlier and a 5.5% jump versus Q1 2022. The same comparisons for cow-calf operation interest rates reveal increases of 2.4% and 3.6%, respectively. For comparison, the quarterly average federal funds rate increased 5.14% from Q1 2022 through Q3 2023.

On top of the rise in interest rates, an increasing percentage of new loans have a floating, or variable, rate. During Q3 2023, a record 93.6% of new loans for feeder livestock had a variable rate, and at 84.5%, cow-calf loans had the fifth-highest percentage of variable-rate new loans since the survey began in 1977 (see Chart).

Fed officials’ projections for the federal funds rate, often referred to as the dot plot, suggest that rates will remain steady through the end of 2023 before declining by about 1% on average throughout 2024.

Responses to Added Costs

In the short term, cow-calf producers are seeing higher rates and interest charges on their variable-rate notes. In the current environment of higher calf prices and general industry profitability, producers pay those higher costs out of cattle sales receipts, which cuts into their potential profits. Since the cow-calf producer is a “fixed-cost operator,” he has no other choice.

The margin operating segments, including stocker operations and feedlots, can have a different initial approach. They can treat the higher rates like they do other variable costs in their budgets and break-even price calculations. They add higher rates to the total cost of growing cattle from one weight class to another. Since they can’t change the expected selling price, they work on the other end of the equation: their purchase decision. This reaction effectively reduces what they can reasonably pay for replacement cattle and still expect to break even or meet their profit objective.

For instance, the decision to retain a heifer calf will reduce the revenue from selling calves. With fewer funds now available to cover costs on running the rest of the cow herd, the operating loan balance will likely increase.

Cow-calf operations that may plan to retain heifer calves to begin herd rebuilding face other cost impacts that can further increase exposure to high interest rates.

For instance, the decision to retain a heifer calf will reduce the revenue from selling calves. With fewer funds now available to cover costs on running the rest of the cow herd, the operating loan balance will likely increase. Add to this the two years of additional carrying cost (without offsetting revenue) to get the retained heifers bred and calved and their first calves marketed, and this will likely lead to operating loan balance growth.

Retained heifers will have a lower conception and calving rate and wean fewer and lighter calves than the mature cows in the herd. This is a function of biology, genetics, and a whole host of management-derived factors that can be mitigated. Ultimately, these factors should be evaluated and accounted for in the operational plan, budget and cash flow projections. To fully establish enterprise cost, producers should extend the projections through another year to capture the full impact of the second year and second crop of retained heifer calves.

Rate Resilience

In the case of stocker and feedlot operations, the added cost of interest has become a drag on prices that, all things equal, should have been more pronounced.

But all has not been equal: Prices for all classes of cattle have rallied over the past two years, all sectors have been profitable, and spreads between the various weight classes have widened. The rally has effectively allowed the added interest costs to be swept under the rug. For context, here are a few examples of how much interest costs have risen for stocker and feedlot operations:

• Average interest costs for financing a $2,750 bred heifer with a 25% down payment for the first year of ownership have increased $49/head since this time last year and have increased $74/head since Q1 2022.
• Financing costs for a 500-lb. steer calf costing $3/lb. going into a stocker operation for five months with a 25% down payment have increased $19/head versus Q3 2022 and $26/head versus Q1 2022.
• Feedlots are facing similar increases, with interest costs for an 800-lb. steer with a purchase price of $2.45/lb. increasing $30/head versus a year ago and increasing $41/head since the beginning of 2022.

Higher Rates and the Herd Expansion

My analysis shows that the net impact of rising rates on stocker and feedlot replacement cattle has limited the rally in calf prices by $50/head since this time last year and $67/head since we entered a higher federal funds rate environment.

For large-scale herd expansion to truly start, moisture conditions must continue to improve, and costs for pasture, forage and interest rates need to decline relative to calf price increases.

I believe this impact on prices has contributed to the smaller and delayed signal for cow-calf producers to expand cow numbers. Many operations have been impacted by drought, higher costs, lower revenue and reduced profitability, resulting in a signal to expand that has been mostly ignored, or deemed too costly, by many producers.

For large-scale herd expansion to truly start, moisture conditions must continue to improve, and costs for pasture, forage and interest rates need to decline relative to calf price increases. When cow-calf producers are ready to expand and deciding their expansion route, they must factor in the impact of interest rates on both the cost of capital and the opportunity cost of lost revenue from delaying a calf crop.

Feedlot and stocker operations will likely respond to the tightening calf crop numbers and smaller calf and feeder cattle numbers outside feedlots by extending ownership to younger and lighter cattle in an attempt to maintain pen or pasture occupancy rates. This will likely require larger operating lines of credit and more exposure to higher rates for most operations. Rallying cattle prices can potentially increase an operation’s available borrowing base, adding a degree of financial flexibility.