Daily Update: Learning To Live With Non-Zero Interest Rates

Interest rates now seem to be on a relentless upward spiral as the Fed embraces its most hawkish impulses in an effort to get inflation back under control. The market is taking every warning from central bankers at face value, raising rate expectations to the point where few on Wall Street would be surprised to see the “short” end of the yield curve (which the Fed controls directly in the form of overnight lending rates) above 3% a year from now.

For investors who have only experienced that kind of rate environment briefly in the last few decades, a lot of mental habits now need to be reviewed and revised. One way or another, the long near-zero-rate era is ending.

However, while the last time overnight lending rates got above 3% was in the brief 2005-8 boom, those who dread a repeat of the 2008 crash can take a little comfort knowing that this is not necessarily the end of the world. Once the initial shock of higher rates starts circulating, I doubt very strongly that the Fed will push the economy straight over a cliff unless conditions are strong enough to support continued tightening moves.

Not Always An Immediate Bust

They’re as skittish about repeating their mistakes as anyone else, and we’ve seen conclusive evidence that they will do whatever they can to avoid causing another cataclysmic recession or even standing idly by while one unfolds. If the job market shows tangible signs of deteriorating, the Fed will pause or even pivot in the other direction for a few months.

We saw this pattern play out in the long 1993-2000 boom, when overnight rates started at 3%, went to 6% and then receded again to spend the better part of a decade oscillating between 4.5% and 5.5%. That era, dominated by “maestro” Alan Greenspan, is also worth noting because the economy avoided lapsing into a technical recession for eight years after the initial rate hikes.

Likewise, while the Fed had to keep tightening rates for two years after the end of the long rolling 1981-2 recession, overnight rates in that cycle peaked six full years before the economy contracted again.

As we’ve discussed, recessions are isolated speed bumps in an otherwise uninterrupted expansive cycle. While the psychic scars they leave behind can be deep and abiding, real recessions are actually fairly rare . . . and officially, we just went through an unusually brief and savage one two years ago.

The Fed ended that one quickly by reversing a tentative rate tightening cycle all the way back to zero. This time around, we suspect Jay Powell and his colleagues would welcome a significant “slowdown” to cool the inflationary fires, but an outright recession will be too much for them to tolerate, especially if it even threatens to approach the scale of what we endured back in 2008.

When Boom Feels Like Bust

So where is the recession talk coming from? The job market remains too hot for policy makers to handle, with an excess of openings and workers free for the first time in over a decade to demand whatever they want from desperate employers.

Household balance sheets are almost preternaturally robust, swollen with stimulus money and access to credit on easy terms. Americans who can spend more are doing so. Demand for everything puts additional pressure on COVID-strained supply chains, and prices step up in response.

Inflation is what makes everything feel miserable. People paying more for everything get nervous, especially if their own pay hasn’t kept up with prices. They’re unable to plan their purchasing, so they panic and buy what they can now, perpetuating the vicious cycle and compounding the Fed’s problem.

Granted, in real terms, adjusted for inflation, economic growth has at best hit a plateau for the time being. We’re all running as fast as we can. And as we’ve noted again and again, in real terms fixed-income investments remain a terrible proposition.

Government bonds offer safe return of your money when they mature, but if they can’t pay a higher interest rate than inflation, the dollars you get back aren’t going to stretch as far down the road. You’re locking in a loss in terms of purchasing power. Nobody wants that!

Our disagreement stems from my refusal to concede that an immediate recession is now inevitable. The odds are elevated but not absolute.

While a slowdown is in the cards, history proves that a hard landing is not guaranteed. Even Goldman Sachs, the bank driving a lot of recession talk lately, now admits that the market has started pricing in 100% odds of a full-fledged recession in the coming year . . . and that worst-case scenario view is excessive.

False Negatives Abound

Worst-case scenarios rarely play out in reality. The market famously predicts nine out of five recessions with clockwork accuracy. That’s not a typographical error. Half the deep economic threats Wall Street runs away from never actually happen.

Investors simply enjoy competing to come up with a scary story. How about that famous yield curve, for example? Isn’t it a sure signal flashing “recession” ahead?

While the Fed has been aggressively raising the short end of the curve with every meeting, the long end is rising to compensate. The extremes are now 2.36 percentage points apart, with all but a few largely cosmetic “inversions” vanishing in the process.

Back in January, when the S&P 500 peaked, that spread was only 1.96 percentage point. Go back a year to when the market was in a great mood and the spread was . . . 2.30 to 2.38 percentage points, depending on the day.

Go back five years before that (2016), when the market was in a great mood and the spread was . . . 2.36 percentage points. Admittedly, a lot of people only look at 10-year Treasury yields, but even they were nudging around 2.6% by December 2016.

Did the world end at any of these moments? Back then, the S&P 500 was trading in a range a little above 2,000. Evidently we all survived that kind of rate environment and investors with a sense of how much risk is “normal” have done extremely well.

Will average mortgage rates above 5% trigger a 2008-style collapse? My team has spoken with a few long-time real estate agents who laughed in our faces at that one. On average, going back five decades, mortgage rates have fluctuated closer to 8% . . . and these aren’t exotic adjustable-rate loans.

These are old-fashioned, vanilla 30-year fixed loans. If the economy could tolerate those credit conditions for decades, what’s changed to make them so dangerous now? I don’t think the American people are any less resilient, hard-working, resourceful or clever when it comes to solving problems.

The economy is arguably more dynamic and more agile than ever. Do you disagree?