A few weeks ago, the DOW was poised to surpass 16,000, seemingly an inevitable milestone. Now, however, the index is experiencing erratic fluctuations, teetering between the 15,000 mark. What’s behind this volatility?
It appears that market apprehension relates to the capabilities of central bankers in managing interest rates. After more than five years of the Fed funds rate hovering near zero, and with 10-Year Treasury yields lingering around 2 percent for nearly two years, concerns are growing that this situation cannot persist indefinitely. Even Alan Greenspan is weighing in.
Perhaps the economy is indeed gaining momentum, rendering excessive monetary stimulus unnecessary. Alternatively, we may be on the verge of a significant devaluation. Either way, a rise in interest rates seems inevitable. But what implications will this shift have?
There’s no denying that ultra-low interest rates have inflated asset prices. Take housing as a prime example. Initially, low rates helped cushion the market’s decline, later buoying prices back up.
So, what can we expect when rates return to more typical levels—say, 4-6 percent? The straightforward conclusion is that as rates rise, prices are likely to drop.
Sinking Back Underwater
But what do we truly understand about these dynamics? We’re merely observing trends and drawing logical inferences. Interestingly, we’re not alone in this viewpoint. Peter Tchir of TF Market Advisors shares similar concerns.
“This entire housing recovery we’ve witnessed over the past year has been supported by much lower rates, which raises significant concerns,” Tchir stated on Tuesday.
In the last five weeks, the 30-year fixed mortgage rates—which generally align with 10-Year Treasury yields—rose from 3.52 percent to 4.1 percent. Practically speaking, Tchir notes, “This increase adds $100 to the monthly mortgage payment for the typical $245,000 home.”
Put simply, prospective buyers face three choices: (1) find a way to afford the added $100 monthly payment, (2) settle for a modest fixer-upper, or (3) wait for housing prices to adjust in response to higher mortgage costs.
We speculate that homebuyers will likely choose a mix of these options. Existing homeowners, who had briefly regained stability earlier this spring, may quickly find themselves underwater again. Yet, it’s not just the housing sector facing challenges due to rising rates…
Almost every market feels the impact—even stocks like Wal-Mart.
According to insights from Talking Numbers, “Whenever interest rates rise, Wal-Mart shares decline.”
Economic Subsistence
The mechanics of this situation are clear. Central bankers, through their monetary interventions, distort market equilibrium. Well-intentioned individuals make decisions that seem rational at the time, only to find themselves blindsided later.
The Federal Reserve aims to create a more favorable economic environment. Remember when Paul Krugman asserted that currency devaluation would spur business growth?
“Increasing the Fed’s inflation target from 2 percent to 4 percent—an idea many policymakers regard as taboo—would incentivize households to spend and businesses to invest, leading to more hiring and economic activity,” Krugman argued a year ago.
Regrettably, his predictions have not materialized. Despite the Fed adding $3 trillion to its balance sheet, we have not witnessed an economic boom. Instead, we’ve seen an economy that relies increasingly on an expanding issuance of cheaper and cheaper credit. Cut that flow, and the price structure collapses.
Contrary to Krugman’s projections, the influx of inexpensive credit did not lead to a surge in job creation, nor did it usher in widespread prosperity.
Instead, stimulus measures have pushed many into an unstable position from which there is no easy return. It’s not a question of if the rug will be pulled out from under us, but rather when.
When that moment arrives, the consequences could be far-reaching.
Sincerely,
MN Gordon
for Economic Prism
