They say a picture is worth a thousand words. The graph below is probably worth more but I’ll try and keep it under a thousand.
This graph takes us back over 40 years ago to 1981 and shows us the history of interest rates (horizontal blue line), major economic events such as crashes or recessions (vertical grey lines), and most importantly, it shows that when the Federal Reserve stops raising interest rates (vertical black lines), a recession usually follows within 6-17 months.
Now before I go any further, I just want to provide a cursory overview of interest rates and explain how and why a central bank like The Fed uses interest rates as a tool to keep the economy in balance. There are lots of nuances and other considerations, but I’ll keep this at a low-level of granularity because we only need a basic understanding to see the big picture.
Here goes…
When the economy is slowing or not doing well, central banks like The Federal Reserve (or the Bank of Canada) typically LOWER interest rates to spur economic activity. The lower interest rates encourages consumers, businesses and governments to borrow, spend and take advantage of the “cheap” money. As consumers are buying goods, doing home renos and taking on mortgages and car loans, businesses are scaling, expanding and hiring more staff. Meanwhile, financial institutions are borrowing money to invest in stocks and commodities and governments are also taking on debt to spend on infrastructure, the military and an assortment of other capital expenditures.
Now on the other side of the coin, when the economy starts rebounding and is doing really well (or TOO well), central banks typically RAISE interest rates which forces borrowers to tighten their belts and spend less. The higher interest rates means that people have less disposable income lying around as more of their budget is going towards servicing their debt. This prevents the economy from overheating and over-inflating as the money in circulation starts to slow down.
So to recap:
BAD ECONOMY > LOWER INTEREST RATES > MORE BORROWING > MORE SPENDING/MORE HIRING > BETTER ECONOMY
TOO GOOD OF AN ECONOMY > HIGHER INTEREST RATES > LESS BORROWING > LESS SPENDING/LESS HIRING > ECONOMY COOLING OFF AND COMING BACK INTO BALANCE
From a theoretical standpoint it’s pretty basic stuff, but we still have a problem.
THE PROBLEM
Go back and look at the graph again and look at interest rates between 2009 and 2017ish (horizontal blue line).
You see that? That’s almost a decade of near 0% interest rates. That’s insanity.
So what happens when you keep interest rates near 0% for almost a decade? You get bubbles. Everywhere. And debt. Lots and lots of debt.
If you remember, lower interest rates encourages people to borrow and spend which then results in an economic boom…so when you keep interest rates near 0% for so long, everybody essentially gets drunk off of the cheap money/credit; consumers keep taking on debt, financial institutions keep borrowing more money to invest (this is referred to as “leverage”), companies keep expanding their credit lines to grow and expand and everybody basically levers themselves to death thinking the good times will just keep on rolling.
At the same time, all of this economic expansion and leveraging has led to price surges across the board and an “Everything Bubble” has formed…we have a housing bubble, debt bubble, commercial real estate bubble, stocks and equities bubble…and we also ended up with sticky inflation that has been relatively immune to the Fed’s rate hikes.
WHERE TO FROM HERE?
Unfortunately, the most desirable outcome - a “soft landing” with a mild recession, a drop in inflation and a slow but reasonable reduction in interest rates - is probably the least plausible. Although The Fed can control their policy decisions, they can’t control the outcome of these decisions, they can only influence them. Regardless, here are their options.
Lower Interest Rates - With inflation still comfortably above The Fed’s 2% target, I don’t see them lowering interest rates anytime soon, at least not in any major way. The Fed is trying to COOL the economy and lowering rates in a meaningful way would be a move towards heating it up. We WILL eventually arrive back at lower rates but I don’t see us getting down to 2-3% until AFTER we have an economic collapse. I’m thinking 2025, maybe even 2026.
Maintain Interest Rates - This is where I see ourselves likely sitting for the greater part of the near-term (2-6 months) although a smaller 25 point hike could also be in play (taking us from 5.5% to 5.75%). I still think The Fed has room to hike maybe 50-75 basis points (total) if they absolutely need to, but it’d be risky and I think they’ll be content to ride out the rest of the year and see how things play out. We won’t really see the true impact of elevated rates until sometime in 2024 when mortgages and leases in both the residential and commercial real estate sectors come up for renewal. Maintaining things as they are seems to be the safest play because lowering rates could re-ignite inflation/entrench it further and raising rates too much too quickly could break something and kick off a collapse.
Raise Interest Rates - When you go back and look at the graph you’ll see that interest rates in the early 80’s were nearly 20%. Could you imagine!? Back then, Federal Reserve chairman Paul Volcker had finally had enough of a multi-year fight with inflation and just decided to crush it once and for all. Of course it led to a severe recession but he stopped inflation dead in its tracks. Fast-forward to today and there is absolutely NO WAY that current Fed Chair Jerome Powell could do the same - not with the insane amount of debt that is in the system today. Back in 1980 the US had less than $1T in debt, today they’re approaching $34T in debt. Completely different times, as shown in the graph below. (Note: In 1980, household debt was around ~$1T, today it's around $17T)
Now like I said earlier, I think Powell and The Fed still have wiggle room to hike 50-75 more basis points but it’s a delicate dance. While Volcker was able to push rates up near 20%, I think Powell can go to 6-6.5% MAX. Anything more than that and the debt bomb will go off. I mean it’s going to go off eventually anyways, but still.
If anything, I could see them raising rates 25 points to 5.75% sometime in the next 2-4 months and then letting it simmer. At the same time, they'd be leaving juuust enough room for some small additional hikes in the future if necessary, although the closer they get to 6% the closer they get to destroying everything.
THE WILD CARD
Glancing back at the graph one final time, I want to point your attention to the vertical black lines with the little numbers above them. That’s the most important part of the graph and shows us that a recession always follows the end of an aggressive rate hiking cycle - it’s not a matter of if, it's a matter of when.
The black lines indicate when The Fed stopped hiking and the little numbers above them are how many months it took for the recession to follow. It casts a pretty wide net (6 months to 17 months) and we currently don’t even know if The Fed is done hiking yet, so we could be a mere month or two way or we could still be a year or two away. I highly HIGHLY doubt we’re two years away though.
But there’s a major wild card this time around that will undoubtedly influence the pace that this plays out; we’re heading into an election year.
If you’re the Democrats, you 100% want to delay the inevitable and kick the can down the road. You want to keep the waters as calm as possible, hope you get elected in November and then once you’re in office you can let shit hit the fan and hope to clean it up by the 2026 midterms.
If you’re the Republicans, you 100% want the economy in the tank by mid-2024 so you have a unifying talking point by the time the Republican National Convention rolls around in July. From there you can beat down on the Democrats for the remaining 3-4 months of the campaign cycle blaming the whole thing on them.
Truthfully, the pending economic collapse is the result of DECADES worth of poor monetary policy by The Fed, DECADES worth of reckless spending by both Democrat AND Republican administrations, regulatory loopholes and blindspots, corrupt regulators and politicians as well as greedy global bankers (aka financial terrorists) who will stop at nothing to milk every last dollar out of this rotting and decaying system.
But most voters don’t know that. They’ll just feel the pain in their bank accounts and blame whoever is in charge at that exact moment.
Anyways, we’re over 1600 words already so I’m gonna have to cut out for now - but just know that the system is entirely fucked and we’re just going to have to take our lumps. We WILL come out the other side though, this I can promise. I also plan on writing some more economic pieces like this so stay tuned. Might do one on the bond market or the Chinese Real Estate crisis but future pieces definitely won’t be as long as this lol.
Peace be with you 🫶
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