Last week the Federal Reserve raised short-term interest rates .25%. This move was highly anticipated and many feel that if the fighting between Russia and Ukraine weren’t going on, the Fed would have raised rates .50% at this meeting. The Fed has indicated that they will continue to raise rates throughout the year – aiming for short-term rates in the 2% range.
Let’s take a quick walk back through history to when inflation numbers were last a serious concern. Back in the late 1970’s inflation numbers were raging, and the government was initiating wage and price controls to try to keep a lid on prices. Howard Ruff – a high profile economist at the time – was describing a “hyperinflationary spiral” that was going to turn the U.S. dollar into tissue paper. A doomsday prognostication of the value of the dollar was widespread. But then Paul Volcker came in as the chairman of the Federal Reserve and raised interest rates drastically. That brought on a recession, but it put an end to the inflation and gave birth to 40 years of asset price increases and a downtrend in interest rates. In September of 1981, the yield on the 10-year Treasury Note peaked at 15.32% - and then in June of 2020, the 10-year rate was just .62%.
Over this period of time, the median prices of houses sold in the U.S. rocketed from $64,900 to $411,200 – an increase of 533% !!! However, during this same period time, the U.S. median income only increased 254%, from $19,074 to $67,521 annually. Essentially, the price of house increase doubled the pace of income increase. That was fueled by cheaper and cheaper credit supplied by the Fed and lower interest rates. Also, cheaper and cheaper labor from Asia supplied the cover that would mask consumer price inflation over this period
The situation is much different now from the perspective of the amount of debt in the system. Since the 1980s the world has aggregately accumulated a total of approximately $300 Trillion in debt (public, corporate and private.) Here is a chart of just US government debt since 1980…
This rocket launch of debt is obviously turbo-charged by continually lower interest rates. Over the last few years, we have even witnessed many trillions of $ of government debt worldwide with a NEGATIVE interest rate. Now with $300 trillion in aggregate world debt the FED is going to raise rates by 2% over the next year? The world economy is roughly $90 Trillion annually and we are going to add $6 Trillion of debt service? Where will governments get the money to pay higher interest on their debts – especially government entities without a printing press – the state of Illinois, for example. Will the housing market hold together with significantly higher mortgage rates? What about corporate debt? Keep in mind that nearly 10% of American publicly traded companies are “zombies” according to our own Federal Reserve. This means that at current interest rates 10% of our companies can’t make enough money to pay their debt service – meaning they have to continue to borrow money and get further in debt to survive. Won’t higher interest rates tip that apple cart over?
The Federal Reserve is also removing the support of debt markets from the $120 Billion of monthly purchases. These debt markets (US Treasuries and mortgage-backed securities) haven’t even stabilized on their own yet – the Fed stated March would be the last month of purchases. We don’t even know what that stimulus removal alone will do to debt markets…
We are having a difficult time seeing the world economy holding together if interest rates continue higher. The 10-year treasury rate is pushing 2.5%. Of course, we don’t know where or when interest rates will push some of the bad debt in the system off a cliff, but we are confident that there will be SERIOUS hiccups in the system before we get to 2% on the overnight rate set by the Fed. We have a big week coming up of economic data and some market observers think the Fed may have to react more aggressively to these numbers and raise interest rates faster than previously suggested. We may see some more volatility in financial markets in short order – so stay tuned!
Regards and good investing!