As the days lengthen and usher in the summer season, a sense of joy permeates the northern hemisphere. The warmth and brightness of this time bring about an ease in mood and an uplift in spirits. However, beneath this cheerful facade, a troubling development is taking place: credit markets are tightening, with the yield on the 10-Year Treasury note surpassing 3.12 percent.
If this upward trend in yields continues, it could dramatically reshape our economic landscape. To grasp the implications of rising interest rates, some historical context is necessary. Where should we begin?
Back in 1981, professional skateboarder Duane Peters was busy innovating tricks like the invert revert, the acid drop, and the fakie thruster in the empty pools of Southern California. His dedication to pushing boundaries came at a cost: a slew of injuries earned him the nickname “The Master of Disaster”. But while Peters was out there performing daring stunts, the foundations of a looming financial disaster were being laid.
Specifically, the peak of that interest rate cycle occurred in 1981. Following that peak, interest rates steadily declined over the next 35 years, scattering the seeds of a significant crisis along the way.
Credit and Asset Prices
The dynamics between interest rates and asset prices are quite clear. When credit is tight, asset prices typically decline; conversely, when credit is abundant and affordable, asset prices tend to soar.
When borrowing is cheap, both individuals and businesses tend to take advantage of it. For instance, individuals often secure large jumbo loans, leading to increased home prices. Businesses, flush with seemingly endless affordable credit, also borrow extensively to buy back their own shares, which inflates stock values and executive compensation.
However, when credit conditions tighten, borrowing is usually limited to ventures that promise significant returns exceeding prevailing rates of interest. This scenario leads to the deflation of financial asset prices.
In 1981, credit was prohibitively expensive while stocks, bonds, and real estate were relatively cheap. For example, the interest rate for a 30-year fixed mortgage peaked at 18.63 percent, with the median sales price of a U.S. house around $70,000.
In contrast, today’s interest rate for a 30-year fixed mortgage is approximately 4.5 percent, while the median home price has escalated to around $330,000, significantly higher along the coasts.
Similarly, the Dow Jones Industrial Average (DJIA) was about 900 points in 1981, while it has now soared to roughly 24,700 points—an increase exceeding 2,600 percent. Over the same period, nominal gross domestic product has risen by only about 500 percent.
It seems evident that 35 years of declining credit has inflated stock and real estate values. This distortion has also affected costs in other areas, such as college tuition, leading to a precarious imbalance between asset prices and borrowing costs. Consequently, this has set the stage for a potential mega-disaster.
The Federal Reserve exerts considerable influence over credit markets, but its power is limited. Changes in the interest rate cycle hold a greater sway over market dynamics than the Fed’s interventions.
From a historical viewpoint, the current yield on the 10-Year Treasury note of 3.12 percent is still notably low, yet it is recognized as quite high when viewed through the lens of the past two years.
The yield on the 10-Year Treasury note was as low as 1.34 percent in early July 2016. Today’s rate marks a dramatic increase of over 130 percent in just 22 months.
Tales from “The Master of Disaster”
The last significant low point in the interest rate cycle occurred in the early 1940s, when rates for the 10-Year Treasury note hovered around 2 percent. Subsequently, rates progressively rose for the next four decades.
Many have forgotten that adjustments made by the Federal Reserve to the federal funds rate have vastly different impacts during periods of rising rates compared to periods of decline. From 1981 to 2016, the Fed routinely cut rates to stimulate demand during economic downturns.
In this disinflationary environment, credit markets mitigated some adverse effects of the Fed’s decisions; asset prices rose, and income levels stagnated, but consumer prices did not surge uncontrollably.
The Fed mistakenly concluded that they had effectively controlled the business cycle. However, this is largely inaccurate. As illustrated during the 1970s, following the U.S. default on the Bretton Woods Agreement, monetary policy becomes increasingly problematic in a rising rate environment.
Federal Reserve officials struggle to respond effectively to rising interest rates, and their attempts to keep rates artificially low in order to stimulate growth become counterproductive. This leads to an environment where monetary inflation gives way to consumer price inflation, making Fed policies tantamount to disaster.
In July 2016, approximately 35 years after its last peak, the credit market finally hit its low and began to rise again. This trend may well continue for the next three decades, resulting in increasingly expensive credit as we move into the mid-21st century. Thus, the era of ever-declining interest rates since the early Reagan administration is drawing to a close.
As for Duane Peters, “The Master of Disaster,” he remains a true iconoclast—more resolute than the shifting credit markets. Now 55, he continues to chase peril with the frenetic energy of a fly colliding with a window. Even without a helmet, his fearless antics frequently result in him suffering injuries on hard concrete yet he perseveres.
In contrast, the Federal Reserve and the dollar face challenging times. The rising phase of the credit cycle could spell their demise. The initial repercussions will manifest as increased interest rates and plummeting asset prices, wreaking havoc globally.
This transition will be far from smooth, and it will undoubtedly be painful.
Our suggestion: Embrace the spirit of “The Master of Disaster.” Face the difficulties head-on and keep moving forward.
Sincerely,
MN Gordon
for Economic Prism
Return from Tales from “The Master of Disaster” to Economic Prism
