In an era marked by a shifting economic landscape, one of the most significant turning points occurred around the time when the legendary Walter Cronkite delivered his final sign-off from the CBS Evening News. This shift, unnoticed by many except financial pioneers like Bill Gross and A. Gary Shilling, was a crucial moment in the U.S. credit market.
With the benefit of hindsight, it becomes clear that the interest rate cycle peaked in 1981, fundamentally altering the economic landscape. In the aftermath, interest rates began a gradual decline that spanned nearly four decades, leading to the growth of colossal asset bubbles.
The interplay between interest rates and asset prices is straightforward. Generally, tighter credit results in lower asset prices, while easier credit tends to inflate them. When borrowing costs are low and accessible, consumers and businesses jump at the chance to acquire assets they might not otherwise afford. This influx of easy credit inflates the prices of assets across the board.
For instance, individuals might leverage low-interest loans to take on substantial mortgages, bidding up housing prices. Similarly, companies using abundant cheap credit might buy back shares, inflating stock prices and the value of stock options for executives.
Conversely, when credit becomes scarce, borrowing is limited to ventures that promise returns exceeding the high interest rates associated with such loans, leading to decreasing financial asset values.
More Pain to Come
In 1981, following a surge of inflation driven by the Federal Reserve, credit became expensive while stocks, bonds, and real estate remained relatively cheap. That year, 30-year fixed mortgage rates hit an eye-watering 18.45 percent, with the median home price averaging around $70,000.
Fast forward to December 2020, and the 30-year mortgage rate fell to a historic low of 2.68 percent, hovering below 3 percent for much of 2021. This environment enabled many to refinance or purchase homes at bargain rates.
As a result, the median home price surged to a record $468,000 by the third quarter of 2022, with coastal regions seeing even higher prices.
However, 2022 marked a turning point as the Federal Reserve raised interest rates aggressively to combat rampant inflation, causing mortgage rates to climb back up to over 6.5 percent. Consequently, home prices are now deflating, with expectations of further declines as the market corrects itself.
In a similar vein, the Dow Jones Industrial Average (DJIA) was approximately 900 points in 1981, but it soared to a peak of 36,799 on January 4, 2022—an astonishing increase of over 3,988 percent. Since then, rising interest rates have led to a decline in the DJIA, which recently closed at 34,053, suggesting potential further drops.
Undeniably, the prolonged period of cheap credit has significantly influenced the inflated prices of both stocks and real estate. Nearly four decades of declining interest rates have distorted asset prices and financial costs, paving the way for an impending reckoning. As 2022 proved challenging for stock and bond investors, more turbulence lies ahead.
Only 37 More Years to Go
The Federal Reserve wields considerable influence over credit markets through its open market operations, yet it is not the sole director of the credit market’s fate. Historical patterns reveal that the dynamics of rising and falling interest rates overshadow the Fed’s interventions.
Currently, the yield on the 10-Year Treasury note at 3.39 percent remains remarkably low, especially when contrasted with the record low of about 0.62 percent in July 2020. This marks a staggering increase of over 446 percent in just 31 months, raising questions about the stability of major investment funds.
Historically, the last major low in interest rates occurred in the early 1940s, with 10-Year Treasury yields around 2 percent. From that point, rates rose consistently for the next 40 years.
While predicting the future is inherently uncertain, examining prior interest rate cycles hints at an alarming reality: we may be at the beginning of another 40-year ascent in interest rates. The financial landscape that has captured the world’s attention since 1981 could be radically transformed.
From 1981 to 2020, whenever the economy stagnated, the Fed slashed interest rates to stimulate the markets. This disinflationary period saw asset prices rise while income growth lagged, aided by cheap imports from China keeping consumer price increases moderate.
The Fed, mistaking serendipity for deft economic management, believed it had mastered the business cycle. Meanwhile, Congress discovered that deficit spending could continue unchecked. However, these assumptions greatly oversimplify the complex economic reality.
Your Broker Has No Clue
Few individuals alive today can recall the stark differences in the effects of Federal Reserve policies during rising versus falling interest rate cycles. The growing pressures of the 1970s, post-Bretton Woods, exposed the limitations of the Fed’s policy tools, undermining the effectiveness of maintaining low federal funds rates in the pursuit of economic growth.
In this era, monetary inflation often culminated in consumer price inflation, revealing the disastrous consequences of Federal Reserve policies.
In July 2020, the credit market finally reached its nadir, with yields now on the upswing once again. This suggests that credit may become increasingly costly well into the mid-21st century, marking the end of the prolonged era of diminishing interest rates we have experienced since the early Reagan administration.
This reality remains largely unrecognized by many politicians, consumers, and investors. Most brokers likely lack a grasp of these substantial changes, leaving uninformed investors, particularly those with limited market experience, vulnerable to miscalculations and risky investments.
Mission Accomplished?
Fed Chair Jay Powell is acutely aware of the volatile inflation patterns from the 1970s and understands the potential consequences of prematurely easing monetary policy. He seeks to avoid the challenges of a high-inflation environment reemerging.
However, Powell faces human vulnerabilities, particularly political pressures. Following a recent 25 basis point rate increase, the federal funds rate has reached between 4.5 percent and 4.75 percent, with prospects of further hikes.
Could this signify the conclusion of the Fed’s aggressive approach? Are we nearing the moment of “mission accomplished”? Some investors clearly gamble on this notion. Post-rate hike, exuberance pushed shares in multiple companies soaring, including Grainger (up over 30 percent), Align Technology (up over 27 percent), Coinbase (up nearly 24 percent), and Meta (up over 23 percent).
What’s the reasoning behind this optimism?
As the U.S. economy appears to be teetering on the edge of recession, consumers are heavily indebted, and layoffs in the tech sector escalate. The degree and duration of this economic downturn will challenge the Fed’s resolve.
The mounting political pressure on Powell could lead to overly hasty decisions, potentially prompting rate cuts later this year—a gamble many investors are willing to take, despite the repercussions of such a move occurring in a fundamentally different interest rate landscape.
Historically, when the Fed cuts rates amid rising interest rates, the outcome can be calamitous, as seen in the 1970s.
While Treasury yields may dip during recessions, the overarching trend appears upward. The experiences of 2022 could be repeated multiple times in the coming decades until around 2060, when we may see a conclusion to this cycle.
Investment choices should be guided by these considerations.
[Editor’s note: Relying on a Fed pivot to secure your financial future is unwise. The current credit cycle poses significant challenges. However, proactive steps can be taken to safeguard your interests. For practical strategies, explore my Financial First Aid Kit, where you’ll find essential insights for thriving in a challenging global economy.]
Sincerely,
MN Gordon
for Economic Prism
