If we think about interest rates in the context of the post-2008 Great Recession world, we can make a few conclusions. First, the Federal Reserve, post Great Recession, reduced interest rates to fight deflation. They implemented Quantitative Easing to fight deflation, to encourage investment, to speed up the velocity of money. They accomplished none of those things. The only thing they did was accelerate the trend for Income to be generated from financial assets rather than from wages. Wages have gone nowhere, and yet financial assets have skyrocketed in value since the crisis. Housing prices, stock prices, and bond prices, have all skyrocketed.
Today, the Federal Reserve is fighting a bubble in financial assets, the same kind of bubble that led to the Great Recession of 2008. The Federal Reserve needs to divert money away from financial assets, and into increasing productivity, increasing the velocity of money.
The fact is, the psychology of crises and and bubbles dictates everything. We saw the same thing happen in the United States during World War II and during the drive to fund the war. At that time, the US government artificially held down interest rates, and did so by instituting price controls on everything that could potentially trigger measurable inflation.
The psychology of the crisis during the Great Depression meant that Americans were more liable to save anyway, and in a sense, there was a constant mindset of preparing for the next crisis. There was an expectation that a crisis would hit after the end of World War II, just as one had hit after World War I.
The difference between today and World War II is that the US now has a national debt that is beyond belief and requires servicing. Artificially holding down interest rates only encouraged people to seek out yield, and to take out more risk. People in World War II did not have that option, and so they either turned to War Bonds, or savings accounts.
Globalization combined with pegged interest rates, leads to financial asset bubbles; war bonds today would fail miserably, which is why US wars in Iraq and Afghanistan were fully paid for with debt.
The initial response by the Federal Reserve to hold down rates was ok, because that initial response was in-line with reality. Rates were low because inflation was non existent, and the economy was contracting (growth and inflation were negative). The problem is that the Fed’s initial response has become a prolonged response. They have continued to hold down rates even as GDP growth has picked up steam, and inflation has increased. The only thing this has done is divert capital to where it most easily can earn a return. Low interest rates in the stock market meant that valuations could be pumped higher and higher, simply on the account of cheap money.
And then companies bought back their own shares, simply because money was cheap, and they sometimes did so on debt, offering their shares as collateral to loans. What we have today is situation where equity and debt are tied together as one, which means just as bond prices and stock prices rose together when rates were low, they will also fall together when interest rates rise.
This will be a painful process, but a required one in order to divert capital back into business investment, things that will actually increase productivity, increase the velocity of money, and provide for sustainable GDP growth going forward.
In addition, taxes will have to go up. There is no way that monetary policy normalization can occur, at the same time fiscal policy is loosened. That is to say, normally, this would be the case. But unfortunately, the Great Recession of 2008 led to both fiscal policy and monetary policy being loosened (tax breaks, government spending, and cheap money, together). We had an environment where monetary policy and fiscal policy were loosened at the same time. We will then have an environment where they will both need to be tightened.
Budget deficits cannot rise infinitely.
Just like in World War II, the government wanted to keep interest rates low, to prevent debt servicing costs (interest payments) from going too high. The only difference is that low rates encourage more debt, from loan seekers, and loan makers. Banks (loan makers) depend on high rates, and specifically, a large interest rate spread between short term and long term interest rates. Why?
Because banks make money by taking in deposits, offering a short term rate on those deposits (savings accounts, CD’s, etc…) and then lending out money at a much higher rate, for the long term (15-30 year mortgages). Interest rates today are making that very hard for banks to do. Below is the interest rate differential between 5 year and 30 year interest rates:
Notice that the difference is effectively 0% today. To be exact, it’s 0.13%. That spread means banks cannot make money on their traditional business. This means that bank stocks, especially after the financial crisis, seriously lagged the rest of the market as the stock market recovered. We can see this below in the chart comparing the S&P 500 returns (purple line) to the XLF (large bank ETF) returns (turquoise line) to the KRE (regional bank ETF) returns (red/green candlestick line).
The S&P 500 has returned 117.17% since July of 2006, while large banks have returned 1.75%, and regional banks 16.75%. The divergence in returns is pretty shocking!
Some say that not all banks are created equal. This is true, but if we look at the different classifications of banks, specifically, regional banks versus large, integrated banks (commercial, investment, and asset management banking), the Yield Curve makes no distinction. From large banks like JP Morgan and Citibank, to smaller regional banks like Bank Of Hawaii and KeyBanc, the shrinking yield has had its effect on all of them, as the above shows.
With that said, since Donald Trump’s election, the possibility of further deregulation of banks and the Trump Tax Cuts, put a little fire in bank stocks. The below stocks hows the performance of both regional banks and large banks, compared to the performance of the S&P 500 (the general market).
For most of the past two years, starting in late 2016 to today, October 18, 2018, the above shows that both regional banks and large banks outperformed the market. Unfortunately the recent market sell-off has hit the bank stocks, and specifically the regional banks, much harder than the S&P 500 and large banks. It should come as no surprise that since Jan 1st, 2018, the yield curve has flattened by 0.30%, further depressing the ability for banks to make money on the spread between short and long-term interest rates.
The only thing that enabled banks to outperform the market recently is the anticipation (and enacted) deregulation, and the Trump Tax Cuts which allowed banks to pocket more profits.
The Wall Street Journal recently put out a piece titled, “Behind Market Turmoil, Potentially Good News”. If you own stocks, you want to read that piece, because at the core of the article, is an analysis of interest rates, and how they are misunderstood.
Interest rates need to reflect two things: economic growth (as measured by quarterly GDP, change over the previous year) and inflation (as measured by CPI – consumer price inflation, or PCE inflation rate – Personal Consumption Expenditures). Interest rates, specifically the interest rate on the 10 Year Treasury note, should roughly equal the sum of those 2 things.
Does it? Well, in the past, sometimes it does, sometimes it doesn’t. And when it doesn’t, bad things have happened. Specifically, recessions have happened, triggered by out of control inflation.
The Wall Street Journal notes the following:
“After the financial crisis, the economy struggled to grow more than 2%, and inflation repeatedly fell short of the Fed’s 2% target. In response, the Fed cut interest rates to close to zero and bought long-term bonds to bring down long-term interest rates.”
In examining our chart above, in the 4th Quarter of 2008, the combination of GDP growth and PCE Inflation totaled -6.8%. This was a massive contraction in the economy, and it was further accelerated by deflation. The Federal Reserve took the Effective Federal Funds rate (the Interest Rate it manipulates) down to 0%, and the 10 Year Treasury rate went down to 1.57% in August of 2012.
The Federal Reserve does not have control over the 10 Year treasury rate. On the contrary, it has direct control over the Federal Funds rate. Notice that the Federal Funds rate and the 10 Year treasury rate have been far below the blue line (inflation + growth). This was purposely done by the Federal Reserve to try and create inflation.
Notice how during the 1960s, the blue line (inflation + growth ) was also far above the interest rates, both the Federal Funds rate and the 10 year Treasury rate. It was the case also in early 1970s and the mid to late 1970s.
Recall that the 1970s were a devastating period for the US economy, because of inflation. The grey shaded areas on the chart show that between 1970 and 1982, 4 recessions took place! Four recessions in 12 years, all triggered by inflation, inflation that was only tamed by a dramatic rise in the Green Line in the above chart (the Federal Funds Rate). Since 1982, a 36 year period, we’ve had 3 recessions, and all (except 2008) were shorter and less painful than the 1970s and 1980s.
The point of all this is to realize that interest rates must reflect the state of growth and inflation, otherwise inflation will get out of control and subsequently destroy growth. When inflation gets out of control, and the Fed is forced to take the Federal Funds Rate aggressively higher, they only add to growth destruction. Recall, high inflation and economic contraction equals stagflation, the worst possible situation. This is what happens when interest rates don’t accurately reflect the state of the economy and inflation.
The below chart should make this even clearer.
The line in the above chart should ideally stay at or near zero. If this was the case, it would mean interest rates perfectly reflect inflation and growth. It’s not the end of the world if the spread between growth + inflation and Interest Rates goes above 0, but the longer and farther it stays there, the greater the danger for stagflation.
Notice during the 1960s, during a decade where the economy was booming and unemployment was at historic lows ( we are actually at those same historic lows today in 2018), the Federal Funds rate was consistently over 5% below where it should have been if it reflected growth and inflation correctly.
What happened in the 1960s is that the war economy (Vietnam and Cold War) launched the US economy into unprecedented growth. The housing market boomed, suburbs were growing, government spending was unprohibited, and everyone had a job. Does this sound familiar?? Here’s hint. We’re going through the same thing today.
The reason why the US experienced such growth in the 60s is the same reason why the 2010s have seen gradual to now explosive economic growth: the price of money (Interest Rates) does not reflect the realities of growth and inflation. Just as in the 1960s, there is a possibility that the economy is overheating, today in 2018. Throughout the 2010s, we have seen and continue to see undervaluation of interest rates by over 5%, just like the 1960s.
One final thing to notice in the above chart is the time period between 1985 and 2000. In those 15 years, not once were interest rates undervalued relative to growth and inflation by 5% or more. There were times when interest rates were actually too high, briefly in 1984, 1990, and 1995, but otherwise, interest rates were conducive, and reflective of gradual and stable economic growth.
It’s no wonder that the late 80’s and 90’s are considered goldilocks years for the US economy.
Jon Hilsenrath is a great reporter with the Wall Street Journal. He put together the following video report on the current state of interest rates. It’s a short and good watch if you’d like a bit more color.