2023-09-28 15:10:28 ET
Summary
- When interest rates pretty much only went down, asset valuations pretty much only went up.
- But now, interest rates have surged. 30-year fixed mortgages are nearing 8%, car loans are nearing 7%, money market funds pay 5.5%, and the Fed may not even be done.
- Does this change your thinking at all about what assets are worth? If it doesn't, you might want to reconsider.
For 14 years after the 2008 global financial crisis, global central banks held interest rates close to zero. In the U.S., cash interest rates never topped 2.5% and were near zero the vast majority of the time. In Europe and Japan, interest rates were even lower. Zombie businesses that would never work in a world with normal interest rates flourished. Vast fortunes were made from unprofitable tech companies, real estate speculation, and venture capital. By 2021, interest rates had pretty much only gone down, and valuations for stocks and real estate had pretty much only gone up. When capital is free, asset prices go to infinity!
After the pandemic and massive government deficits sparked runaway inflation, this model was shattered into a million pieces. Interest rates continue to surge, and I'm not sure that those who haven't studied history know what they're up against when they're paying stale prices for assets. The 10-year Treasury (US10Y) has surged even higher to 4.65% as of my writing this, up dramatically from its COVID low of 0.31%. While it may not sound like much, this implies mortgage rates of nearly 8% and auto loan rates of 7%.
3% Mortgages– Long Gone
Yesterday, the 30-year fixed mortgage hit 7.65% , with more possible increases to come today with bond yields continuing their landslide. Investors are paying even more. At the same time, home prices are still up about 40% from pre-pandemic. For some rough math, buying a $500,000 house with a 3% mortgage costs you $1,686 per month in principal and interest. Add in the 40% increase in home prices and finance it at 8%, and that principal and interest payment is $4,109 per month. At this rate, we might be at 8% mortgages in a matter of weeks.
Should you still borrow as much as possible to buy a house? I think it's the biggest financial mistake that you as a young six-figure earner could make, especially since you can put your 20% down payment in a money market fund and earn hundreds of dollars per month in interest @5.5%. And if you don't think so, the price of money may keep going up until you do, courtesy of massive government deficits and the Fed's inflation-fighting mandate. I've covered housing extensively over the past 18 months.
Some readers will think my work is a total airball because prices are only down like 1% from the peak. There's still time. I don't think the economy is going to handle 8% mortgage rates well at all and we're about to find out who's right. For now, homebuilders have sold millions of homes with temporary teaser rates. When these reset, I think a lot of dual-income overleveraged people will be in trouble.
Will we see 9% mortgages? We're not that far off. Old-timers may recall mortgage rates this high or higher, but to put them in context, you need to compare home price-to-income ratios as well to get debt-to-income numbers. DTI numbers for buyers are at a record high , despite a lack of population growth and a rapid pace of construction. It doesn't add up!
History Tells Us That Rising Rates Will Start To Put Pressure On Government Spending
Consumers largely refuse to save money, and the government is looking to borrow as much as possible as well. It's simple supply and demand– if everyone wants to borrow and there are few people willing to lend, then interest rates go up. People on the Internet say the Fed will just print more money to bail everyone out, but they really can't legally do it with their inflation mandate. History is filled with governments who print money to monetize the debt and wipe out the middle class.
However, at least in the U.S. and Western Europe, central banks have experience fighting inflation and understand the long-term economic consequences of letting inflation skyrocket. In the U.S., the public was sick of the shortsighted economic policies of the late 1960s and 1970s and double-digit inflation. Fed chair Paul Volcker took a stand, smashing the inflationary psychology via an engineered recession. Germany cracked down even further on inflation, having learned from the traumatic, ingrained experience of the Weimar Republic hyperinflation. Interestingly, that generation's children and grandchildren are today's business leaders there, and their thinking largely influenced the euro and the idea of governmental austerity in Europe in the 2010s.
At this point, it's highly unlikely that the Fed will turn around and print a bunch of money because doing so might drive inflation back not to 8%, but to 20% or more annually. History shows that Congress eventually gets the message, as they did when bond vigilantes forced both the Clinton administration and the Obama administration to cut spending.
What good economists would tell about the large deficits of Bidenomics is that there's a risk of " crowding out " the rest of the economy. Huge government deficits need to be financed by borrowing, and finding buyers financing the debt means that interest rates go up. People always say the government spends too much, but to run these kinds of deficits during peacetime and economic expansion is unprecedented . This has the obvious effect of diverting economic activity that would happen in the private sector to the government. Worse, so-called bond vigilantes can stop buying government debt, sending interest rates skyrocketing.
Famed hedge fund manager Bill Ackman recently placed a massive bet on rising interest rates in the U.S., which he's winning in spectacular fashion. He thinks the 30-year Treasury will go to 5.5%– this implies mortgages would be at about 9%. It seems that the lessons of the 1970s have been forgotten, with $2,000 stimulus checks offered up by both parties as the reward for voting for them in 2020. We're paying for those now.
The U.S. government either needs to cut spending or raise taxes, or interest rates might just keep going up. This inflation surge shouldn't have happened – the Fed should have ended QE far earlier, and raised rates sooner. The federal government should have spent about a trillion less in 2021, 2022, and 2023. I'm speculating here, but I think if they had, then interest rates would be 3.5% or so and inflation would be a bit above 2%.
Want To Buy A $60,000 Used Pickup Truck For 7% Interest?
Mortgages get all the attention, but cars and trucks are expensive. They're even more expensive when you can't pay cash and need to finance them. Pre-pandemic, car loans were cheap (3-4% for good credit). Now, customers often need to pay over 7%. On a $50,000 car loan, that's the difference between paying $898 per month and paying $990. Car loan payments aren't as sensitive to interest rates as mortgages, but as amortizations get longer, the effect is greater. Again here, used cars are up about 40% since pre-pandemic, so there's a compounded effect. Last I looked, salaries are up about 15-20% since pre-pandemic, so cars and houses being up 40% each is bad news. Will American automakers sell as many cars with higher interest rates? Economic theory says no. There likely will need to be a transition towards more economical cars, be they electric vehicles ("EVs") or hybrids, because aging consumers with thin balance sheets don't have any business with $1,000 car payments.
I think this explains why the Fed and the White House are puzzled by why consumer confidence is so low despite unemployment being low. If I waved a wand and awarded you a $100,000 job but you have minimal other assets, in 2019 you could buy a house and car. Now, your options are much more limited, first because of pandemic shortages from money printing, and now because of skyrocketed interest rates. Despite making a little more money (on paper) than before, people are worse off in terms of purchasing power unless they went into the pandemic owning one or more houses and cars.
Regional Banks?
In March, we saw several regional banks fail in rapid succession. Since then, things have been quiet, although interest rates have increased and lending standards have steadily tightened. If you recall from March, what crushed these banks was having far too much leveraged exposure to long-duration bonds yielding 1% or whatever when they got flooded with deposits in 2021. Then interest rates rose and rose until some banks went broke. While betting on bonds with leverage is historically a good trade (if you have some yield to work with), it requires a higher level of risk management skill. Banks like Silicon Valley Bank ( SIVBQ ) didn't have that skill, so they went bust.
I wonder what else is lurking out there with these regional banks! The 10-year hit a new post-crisis high today, and while companies like Charles Schwab ( SCHW ) took decisive action to fix their balance sheets, I bet a lot of them just stuck their heads in the sand. I'm not going to name names of banks I think are in trouble, but if you see some of these regional banks in the headlines soon being closed for losses, then you should not be surprised.
I think it's also worth noting that like many parts of the economy, certain banks and fintech-type companies thrived in an environment where interest rates only went down. If they bet the farm on it, they're going to lose the farm if interest rates keep rising.
Ignore Rising Rates At Your Peril
Rising rates have a direct impact on the stock market by affecting the leading sectors of the economy that rely on loans (housing, autos, etc.). Another channel that interest rates work through is increasing bond yields and thus financing costs for companies over time. Rising rates also have an indirect effect on the stock market by allowing you to earn interest risk-free in money market funds.
While many investors think things like "housing is the best investment ever and nothing can stop it," there should be some level of interest rates that makes them change their minds. Maybe it's a 5% mortgage rate, maybe it's 7%, 8%, or even 10%. Similarly, for stocks, there should be an interest rate on cash that makes you change your mind about wanting to own them. If the government decided that they'd pay 20% risk-free in Treasuries, would you really want to be punting your money on the NASDAQ ( QQQ )? Recall that in the 1970s and 1980s, S&P 500 (SP500) valuations fell to less than half of where they are now due to interest rates being sky-high.
The question right now – cash interest rates are at 5.5%, while long-term interest rates are rapidly rising. Stock prices don't really make sense, either on a macro level or whether you dig into blue-chip companies and project their cash flows. Do you want to buy stocks for near-record-high valuations, or keep some of your money in cash? It's not an all-or-nothing decision, and the higher interest rates go, the more apt you should be to save and the less you should be to borrow. American consumers just haven't gotten the message yet, with savings rates near record lows. They will though, because the price of money will keep going up until it induces them to save.
Lastly, the yield curve is sending a message. Inverted yield curves are associated with a recession warning, but once the recession actually starts, the yield curve tends to rapidly steepen. Often the curve steepens because the Fed is cutting, but if it's steepening because interest rates are skyrocketing, it likely has the same effect. This will be a real business cycle, not the computer simulation/science experiment that the COVID economy was.
Bottom Line
Has a recession already started and we don't know it yet? Student loans for 40+ million borrowers are due on October 1st. It will be interesting to see how everything shakes out. Volatility seasonally rises in most years in the autumn , and we're right on schedule, but it's not like the bottom has fallen out yet. Whether the rising interest rate landslide continues is likely key to knowing where markets go next. If we see the 10-year Treasury push towards 5.5% and mortgages make a run at 9%, then it's probably game over for the 2023 mini-bull market, with some combination of a housing crash, bank failures, and stock investors forced to face the reality of steadily rising financing costs for corporate America. Stay safe out there! What do you think? Share your thoughts in the comments section!
For further details see:
Will Rising Interest Rate Avalanche Crush The Economy And Markets?