Navigating the Challenges of Interest Rates
Economic forecasts are rarely straightforward. Recent actions from the Federal Reserve illustrate the complexities involved.
On September 18, the Federal Reserve elected to lower the federal funds rate by 50 basis points, marking its first reduction since March 2020. This decision was influenced by voices such as Elizabeth Warren, who critiques Fed Chair Jerome Powell for being “behind the curve.”
However, an unexpected trend emerged following this cut. Rather than decreasing, the yield on the 10-Year Treasury surged, defying the Fed’s expectations.
As of this week, the yield on the 10-Year Treasury soared above 4 percent for the first time since July 31, with the 2-Year Treasury note also surpassing the 4 percent mark. This demonstrates a disconnect between the Treasury market and the Fed’s intention of reducing borrowing costs.
So, was Warren mistaken? Is the Fed indeed not lagging behind? Was the rate cut in September a misstep? And will a further reduction in November exacerbate this error?
It’s essential to understand that bond prices move inversely to yields. As yields rise, bond prices decline. This shift results in elevated borrowing costs for government financing, impacting everything from mortgage rates to corporate loans.
In truth, the rationale behind the Fed’s September 18 rate cut was less about economic lag and more about facilitating the Treasury Department’s management of Washington’s massive debt.
However, as Treasury yields climb, the cost of financing this debt increases. With interest payments projected to exceed $1 trillion in fiscal year 2024, it becomes an ever-growing portion of Washington’s inflated budget.
Constraints on Government Intervention
While the Fed exerts substantial influence over credit markets, it does not wield complete control. The broader long-term trends of the interest rate cycle often overshadow the Fed’s interventions.
For instance, the 10-Year Treasury rate peaked at over 15 percent in September 1981, followed by a general decline over the ensuing 39 years. Although there were occasional upward spikes, the overarching trend was downward.
The Fed capitalized on this long-term descent in interest rates to elevate both stock and bond prices, leading investors to rely on the “Fed put” to buoy these markets. Whenever the S&P 500 saw a 20 percent drop, the Fed would typically respond with interest rate cuts.
This coordinated intervention resulted in notable market distortions between 1987 and 2020. On one hand, bursts of liquidity created a safety net for stocks; on the other hand, the cuts inflated bond prices, as bond value moves inversely to interest rates.
Lower interest rates also enabled overleveraged entities—businesses, individuals, and the government—to refinance at more favorable costs. The Fed’s implicit program has effectively functioned as counter-cyclical stimulus for the stock market since the mid-1980s.
This paradigm shifted dramatically in July 2020 when the 10-Year Treasury rate plummeted to a historic low of 0.62 percent. Over almost four decades, savers were progressively disadvantaged, while those taking on leverage prospered.
The Long-Term Interest Rate Landscape
During this era, borrowers—ranging from individuals to governmental bodies—were able to take out substantial loans, investing them in various assets like real estate, only to refinance at continually lower rates. Consequently, while debt servicing costs decreased, asset prices surged.
Since July 2020, however, interest rates have been on the rise. Last Wednesday, the 10-Year Treasury rate hit 4.09 percent—a low point in historical context but significantly higher than the 0.62 percent observed three years ago. This rapid ascent presents substantial challenges.
The intention behind the Fed put extended well beyond supporting stock and bond investors. Its primary function was to rescue major banks, large businesses, and to ensure that Washington had access to affordable credit. For over 37 years, U.S. financial markets have displayed signs of manipulation.
Now that the interest rate trend is reversing, the Fed’s capacity to stabilize the stock and bond markets during financial turmoil is diminished. Consequently, it can provide less low-cost credit to the government, explaining the rise in Treasury yields post-rate cut.
The transition from an era of historically low rates to one nearing historical averages is fraught with underappreciated risks. Initial signs of distress have surfaced, evident from the sharp decline in bond prices between mid-2020 and late-2023, with strategists at Bank of America dubbing this period “the greatest bond bear market of all time.”
Yet, this bond bear market may persist for decades.
Lessons from History
Since late-2023, the 10-Year Treasury yield has stabilized slightly, prompting many to believe the worst is behind us. This belief is misguided; the long-term ascension remains intact, and as interest rates resume their upward trajectory, further distress is likely.
Those who examine a chart of historical 10-Year Treasury yields will notice that trends develop over decades. The last trough in interest rates occurred in the early 1940s with a yield around 2 percent, followed by a 40-year period of rising rates.
What many forget is that the Fed’s adjustments to the federal funds rate wield distinctly different impacts during rising interest cycles compared to declining ones.
When the Fed employed rate cuts to stimulate demand from 1987 to 2020, the effects were tempered and the credit market mitigated some negative consequences. While asset prices surged, income stagnated, consumer price inflation remained in check, aided by inexpensive oil and consumer goods from overseas. This led the Fed to falsely believe it had tamed the economic cycle.
However, as the Fed experienced in the 1970s following the U.S. default on the Bretton Woods Agreement, efforts to maintain low federal funds rates amid rising interest rates often resulted in disastrous outcomes. The mistakes made during that decade echo today, as Fed Chair Powell’s recent rate cut appears reminiscent of past errors.
Conclusion
The current economic landscape is laden with complexities. Understanding the interplay of government intervention, interest rates, and market dynamics is crucial for navigating these uncertain times. As the Fed continues to respond to evolving economic conditions, it’s essential to remain vigilant about past lessons to avoid repeating them.
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Sincerely,
MN Gordon
for Economic Prism
