In the realm of finance, speculative manias can significantly skew the connection between financial markets and the actual economy. When stock market indices, such as the S&P 500, soar, they often become detached from economic fundamentals, transforming these indices into mere vehicles for speculation.
Over the past four decades, the Federal Reserve’s monetary policies have penalized traditional values like hard work, prudent saving, and self-sufficiency. Instead, these principles have often been undermined by misleading strategies.
One striking example can be seen in the 10-Year Treasury rate, which peaked at over 15 percent in September 1981. Following this peak, the Federal Reserve orchestrated a systematic decline in interest rates over the next 39 years. The so-called Fed put—an approach that involves lowering interest rates whenever the S&P 500 experiences a 20 percent drop—became a reliable safety net for stock and bond market investors.
This centrally managed intervention led to notable market distortions. First, the influx of liquidity effectively elevated the minimum threshold at which the stock market could fall, known as the put option effect. Second, the resultant interest rate cuts inflated bond prices, as prices move inversely to interest rates.
Lowering interest rates also enabled heavily indebted businesses and individuals to refinance at more favorable rates. Through the Fed put, the central bank has quietly maintained a counter-cyclical monetary stimulus for the stock market since the mid-1980s.
This landscape shifted in July 2020 when the 10-Year Treasury rate plummeted to a historic low of 0.62 percent, representing a 5,000-year low for borrowing costs.
Throughout this prolonged period, savers were increasingly offered lower returns, while those addicted to leverage saw their fortunes soar.
Underappreciated Danger
Individuals and corporations eager to capitalize on cheap credit took advantage of the opportunity to amass significant debt, investing heavily in assets like real estate and other businesses. This strategy was sustainable as long as interest rates remained low, allowing debt servicing costs to decline alongside spiraling asset prices.
However, since July 2020, interest rates have begun to rise, with the current 10-Year Treasury rate hovering around 4.05 percent. Although this figure still appears low historically—averaging 4.49 percent over the last 150 years—it’s a stark increase from the previous 0.62 percent.
This rapid shift poses significant challenges. The Fed put, which was revised in 2008 to encompass the purchase of Treasuries and mortgage-backed securities, aimed to do much more than just support stock and bond investors; it was primarily designed to bail out large banks and corporations while ensuring financial markets remained buoyant.
Now, with interest rates needing to remain relatively elevated to combat rising consumer price inflation, the Fed’s capacity to support the stock and bond markets during financial turmoil is considerably diminished.
The risks involved in transitioning from an era of historically low rates to one approaching historical averages are often overlooked. For instance, this shift was a key factor in the recent collapse of Silicon Valley Bank.
Without the Fed put providing a safety net, a wave of corporate defaults could precipitate a market crash.
Corporate Defaults are Coming
During the period of minimal rates, numerous businesses took on substantial debt. However, many initiatives that seemed feasible when borrowing costs were negligible may now become unprofitable at current interest rates. Over the next few years, companies will likely struggle to refinance their debts under conditions that still allow for profitable operations, presenting a major challenge.
The significant wave of corporate refinancing for high-yield bonds is expected to gain momentum in 2025 and peak by 2028. In the interim, corporate debt markets—aside from those rated CCC or lower—appear to be largely indifferent to the approaching crisis. Many investors anticipate that central banks will step in to assist these heavily indebted corporations by lowering rates. According to the Wall Street Journal:
“The belief that rates will soon start coming back down still pervades the corporate-bond ecosystem. For one, ratings firms haven’t lowered the grades they give these bonds as a measure of default risk. According to S&P Global, debt classified as ‘investment grade’ is still enjoying more upgrades than downgrades. Higher-yielding ‘speculative’ or ‘junk’ bonds are being marked down, but less than in 2019.”
“One reason is that most of the corporate bonds outstanding today won’t start maturing until 2025, data shows, as firms used low rates to lock in long-term debt. Rating agencies typically raise alarms closer to refinancing deadlines.”
For now, situations seem stable. However, the fact that rating agencies are overlooking a looming wave of corporate defaults doesn’t mean a crisis isn’t brewing.
For the first time in four decades, the Fed might not provide a bailout—at least not in the traditional sense of lowering interest rates.
Welcome to the Era of Targeted Bailouts
Since March 2022, the Fed has raised the federal funds rate ten times, pushing it from near-zero levels to a range between 5.00 and 5.25 percent. These increases aim to curb the rampant consumer price inflation largely attributed to the Fed’s own actions.
Last month, the Fed paused its rate hikes, yet further increases are likely after the upcoming FOMC meeting. In parallel, Quantitative Tightening 2 (QT2) began on June 1, 2022. Although the Fed initially reduced its balance sheet by $626 billion through February 2023, it subsequently added roughly $400 billion, which was utilized to support depositors of SVB through a program called the Bank Term Funding Program (BTFP).
Following this, the Fed continued with QT2, bringing its balance sheet down to approximately $8.3 trillion—roughly where it stood prior to the SVB collapse.
This scenario illustrates how the Fed plans to intervene in both the economy and financial markets during times of persistently high consumer price inflation. Rather than indiscriminately slashing interest rates, these interventions will likely take the form of targeted bailouts, such as the BTFP.
At Economic Prism, we stand firmly against all forms of market intervention and bailouts. The notion that unelected officials can effectively manage a complex economy of 330 million people is deeply disconcerting.
Moreover, in this new era of targeted bailouts, something even more concerning is at play. The Fed will actively select which entities receive assistance, determining clear winners and losers in the process.
In essence, if you’re not a banker or part of a favored corporation, you may find yourself without a lifeline.
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Sincerely,
MN Gordon
for Economic Prism
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