In the aftermath of extensive monetary expansion and unprecedented levels of debt incurred during the pandemic, the initial excitement has subsided, leaving a challenging reality in its wake. Though the tide of money creation has decreased – at least for the moment – the trend of escalating debt continues unabated.
The fallout from soaring consumer price inflation, vast government debt, and numerous economic distortions may never have justified the initial decisions that led us here. As the remnants of government stimulus fade, a significant reckoning is on the horizon.
What might unfold if the labor market falters and consumers burdened by debt begin losing their jobs? We may find ourselves confronting this reality sooner than anticipated.
Market analyst Gary Shilling predicts a recession may materialize by the end of this year, possibly elevating unemployment rates to 7 percent. He also forecasts that stocks, which have surged due to speculative behavior, could plummet as much as 30 percent—potentially resulting in a tumultuous decline.
“Looking at the level of speculation out there reveals a lot of overconfidence, which typically results in a corrective backlash that can be quite brutal.”
As outlined last week, we believe the U.S. has embarked on a new era of persistently rising interest rates. This trend may fluctuate upward for the next thirty years—or longer.
The critical turning point occurred in July 2020, when the yield on the 10-Year Treasury note reached a historic low of just 0.62 percent, signaling the end of a 39-year decline in interest rates.
However, the reversal of such entrenched trends in the credit market often unfolds gradually. Investors, accustomed to a long-standing paradigm, may struggle to grasp the implications of these seismic shifts happening right before their eyes.
Let’s delve deeper.
Projecting the Past
Back in the early 1980s, many investment experts were shaping their predictions based on outdated assumptions. Following a decade of rampant inflation, the prevailing wisdom suggested that wealth preservation required investments in gold, fine art, and antiques.
This approach was believed to safeguard wealth against spiraling prices, as historical patterns seemingly pointed to ever-higher inflation.
After Nixon ended the gold standard in 1971, inflation intensified, leading to fears that the U.S. was on the brink of complete economic chaos.
Investment advisor Howard Ruff, in his publication The Ruff Times, insisted that hyperinflation was imminent, depicting the dollar as destined for ruin, much like conifer trees ignited by a California wildfire.
However, an unexpected development occurred: under the leadership of Fed Chair Paul Volcker, high interest rates instigated a recession. This pivotal moment stabilized inflation and ushered in a new phase of asset inflation in stocks, bonds, and real estate—though the implications were not immediately understood.
By September 1981, the yield on the 10-year Treasury Note had peaked at 15.32 percent. Many investors expected yields to continue rising. This is when Franz Pick controversially declared, “bonds are certificates of guaranteed confiscation.”
Yet, what followed was extraordinary: yields embarked on a 39-year downward trend, culminating in June 2020, when they dipped to 0.62 percent.
Admittedly, a few contrarians in the late 1970s, like Gary Shilling, anticipated the shift long before it came.
On the Money
Instead of subscribing to the consensus belief that inflation would forever dominate, Shilling sensed an impending era marked by declining interest rates and subdued inflation. In this context, traditional inflation hedges would perform poorly, while financially leveraged assets would thrive.
Shilling’s conviction prompted him to author a book highlighting these insights, titled Is Inflation Ending? Are You Ready? Despite its critical message, the book flopped in sales; few were willing to entertain the notion that inflation was receding.
Ultimately, Shilling’s forecast was remarkably accurate. Not only that, but he backed his insights with decisive actions, achieving financial independence through aggressive long-bond investments by the mid-1980s.
His exceptional call and strategic placement of capital into the declining interest rate trend starting in the early 1980s is a testament to his foresight. Moreover, his ability to navigate this trend long after established investors like Bill Gross exited is equally impressive.
Many believed interest rates had reached their lowest point in late 2008 during the financial crisis. The Fed’s aggressive purchasing of mortgage-backed securities and Treasuries—exacerbated by $8 trillion in newly created credit—sustained low rates until July 2020.
Additionally, inexpensive consumer goods from China and affordable domestic oil and gas prevented rates from rising as they might have otherwise. However, these forces can no longer keep inflation in check as they once did.
What You Must Know About Interest Rates
Currently, interest rates are climbing. Yet, much like their previously consistent decline, the rise will not follow a continuous, smooth path.
If you examine a long-term chart of the 10-Year Treasury yield, you’ll observe the overarching trend interspersed with sudden fluctuations that can catch investors off guard.
Take, for instance, the interest rate spike in 1994 that led to Robert Citron’s disastrous performance with investment strategies labeled as “step-up double inverse floaters.” Citron, who served as Orange County, California’s treasurer for 25 years, oversaw a staggering loss of $1.64 billion in public funds, resulting in a historic municipal bankruptcy—and ultimately, jail time for him.
Citron wasn’t alone; several prominent financial failures, like Long Term Capital Management in 1998 and Lehman Brothers in 2008, also stemmed from unanticipated interest rate hikes.
The take-home message is this: unlike the trajectory from 1981 to 2020, we are now in a period where interest rates are expected to rise. Consumer price inflation is increasingly likely to be a constant factor going forward, as the previous curbs on inflation have diminished.
Nevertheless, we may still encounter episodes of declining interest rates, similar to the period between July 2020 and now. When they do occur, it’s wise to appreciate them.
It is possible that a predicted 30-percent fall in the stock market—foreseen by Shilling—could temporarily influence interest rates downward. However, it’s essential to acknowledge that yields for 10-year Treasuries will not revert to 0.62 percent, nor will they settle at 2 percent again.
The era of cheap money is behind us for good. The Federal Reserve may attempt to defy this reality, but it cannot halt the inevitable.
And like Citron, the U.S. Treasury may soon find itself in an uncomfortable position.
[Editor’s note: It’s astonishing how a few strategic decisions can significantly alter one’s financial landscape. At this very moment, I’m gearing up to make another contrary decision, and >> I would love to share how you can do the same.]
Sincerely,
MN Gordon
for Economic Prism
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