This week, following the FOMC meeting, the Federal Reserve decided to maintain the federal funds rate, keeping it steady at a range of 5.25 to 5.5 percent. This decision was largely expected.
The more significant developments were unveiled in the implementation note. Starting June 1, the Fed plans to reduce its monthly balance sheet reduction of U.S. Treasuries from $60 billion to $25 billion. Essentially, this means $105 billion less in Treasuries will need to be issued in the third quarter.
The Fed is essentially striving to curb rising interest rates. This move may provide temporary relief for both the Fed and the overextended financial system, particularly during an election year. However, given the persistently high inflation and a balance sheet still exceeding $7.4 trillion, the pressure is mounting to confront these economic challenges.
There are forces at play that extend beyond the Fed’s monetary policy. Understanding these dynamics will position you ahead of the curve, outpacing 99 percent of your peers and even many experts. So, where should we start?
On Thursday, despite the Fed’s taper announcement, the yield on the 10-Year Treasury note closed at 4.58 percent, approaching the 16-year high of nearly 5 percent reached last October. After a few months of decline, yields are once again climbing.
As yields rise and credit markets tighten, one critical factor is destined to alter the landscape. In fact, that shift is already in motion.
We find ourselves in an era defined by rising interest rates—a phenomenon not experienced by Americans in over four decades. Yet, this aligns with the long-term trajectory of the credit cycle. To grasp the situation, it is essential to look back and identify several key turning points.
Interest Rates and Asset Prices
In September 1981, a pivotal moment occurred; the ascent of interest rates reached its zenith. Interest rates had been climbing for more than 40 years, leading many to believe that the trend would persist indefinitely.
Surprisingly, rates did not continue their upward trajectory. Instead, they began to decline—and did so consistently for the next 39 years, setting the stage for a potential disaster.
The connection between interest rates and asset prices is typically clear. Tight credit conditions tend to depress asset prices, while abundant credit usually inflates them.
When borrowing becomes cheap and accessible, individuals and businesses often take on debt to acquire things they otherwise couldn’t afford. For instance, individuals with substantial jumbo loans drive up housing prices, while companies frequently capitalize on easy credit to repurchase shares, inflating their value and executives’ stock options.
Conversely, tight credit translates to prudent borrowing, reserved for ventures promising returns that exceed the prevailing interest rates. This pressure leads to decreased asset prices.
In 1981, credit was costly while stocks, bonds, and real estate were relatively inexpensive. Notably, the interest on a 30-year fixed mortgage peaked at 18.45 percent. During that period, the median sales price for a U.S. home stood at around $70,000.
In stark contrast, the interest rate on a 30-year fixed mortgage hit a low of 2.68 percent in December 2020, with the median home price inflating to a peak of $479,500 by late 2022. Prices surged even higher along the east and west coasts.
Similarly, the Dow Jones Industrial Average (DJIA) was approximately 900 points in 1981, now soaring to about 38,225 points—an increase of over 4,147 percent. During this time, however, gross domestic product has only risen by about 805 percent.
Trend Reversal
The nearly four-decade period of increasingly cheaper credit significantly contributed to soaring stock and real estate prices. This extensive influx of credit also distorted various costs associated with assets, such as college tuition and vehicle prices.
Moreover, the gap between high asset prices and low borrowing costs has set the stage for a potential monumental disaster. As interest rates climb, asset prices will need to follow suit and decline. As of the end of last year, the median sales price for a U.S. home has decreased to $417,700—down over 12 percent from its peak.
While the Federal Reserve exerts considerable influence over credit markets, it is not the ultimate authority. Indeed, the Fed’s interventions are secondary to the overarching trajectory of the interest rate cycle.
From a historical lens, the current yield of 4.58 percent on the 10-Year Treasury note aligns closely with its long-term average of 4.49 percent. However, considering the past three years, this yield appears extraordinarily high.
Specifically, the yield on the 10-Year Treasury note plunged to a record low of 0.62 percent in July 2020, and today, at 4.58 percent, has risen dramatically—an increase of over 638 percent in just 46 months.
The last significant trough of the interest rate cycle occurred in December 1940, with a yield of 1.95 percent on the 10-Year Treasury note, after which rates generally increased for the next 41 years.
What many overlook is how the Fed’s adjustments to the federal funds rate convey vastly different implications during upward and downward shifts in the interest rate cycle.
Policies of Disaster
From 1987, marked by the Greenspan put, to 2020, any economic softening prompted the Fed to lower interest rates in an effort to stimulate demand. In this environment of disinflation, the credit market tempered the adverse outcomes of these interventions.
Undoubtedly, asset prices inflated, while incomes stagnated. However, consumer prices didn’t soar to alarming heights. The Fed interpreted this as evidence of its ability to manage the business cycle, which was far from the truth.
During the upward segment of the interest rate cycle, as seen in the 1970s after the U.S. defaulted on the Bretton Woods Agreement, the Fed’s interest rate strategy repeatedly faltered.
Throughout that decade, much like today, policymakers found themselves politically unable to stay ahead of rising interest rates. Their attempts to maintain low federal fund rates to stimulate growth failed to yield anticipated results.
Over the past few years, monetary inflation combined with deficit spending has led to rising consumer price inflation. Policies implemented during the upward phase of the interest rate cycle are undeniably disastrous.
Since July 2020, interest rates have finally peaked after nearly four decades of decline. Yields are on the rise once more, and the Fed is powerless to halt this trend. Indeed, we may be facing decades of rising interest rates ahead.
This suggests that the cost of credit will increasingly escalate as we approach the mid-21st century. The era of continuously decreasing interest rates, which began during the early Reagan administration, allowing individuals to refinance their debts repeatedly, is drawing to a close.
All of this transpires amid a backdrop of record levels of household, business, and government debt. Adapting to this new landscape of rising interest rates will require practice for households, businesses, and investors alike. Those burdened by excessive debt risks facing bankruptcy.
The implications for government budgets and debt servicing will be unsustainable. Furthermore, this is likely to lead to a serious depreciation of the dollar.
[Editor’s note: It is remarkable how a handful of strategic decisions can result in transformative wealth. At this juncture, I am gearing up to make another decision that deviates from the norm. >> I would love to share how you can do the same.]
Sincerely,
MN Gordon
for Economic Prism
