“In Fitch’s view, there has been a steady deterioration in standards of (US) governance over the last 20 years, including on fiscal and debt matters. The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.”
-Fitch Ratings, on its recent US credit rating downgrade.
The quiet murmur of rising interest rates has now grown to the roar of an approaching freight train. The 10-year yield continues to rise, hitting a fresh 52-week high this week over 4.3%. The 30-year fixed-rate mortgage reached 7.48% this week and is now threatening to rise above 8%. After over a decade of zero-interest rate central bank policies (a.k.a. ZIRP), surging inflation sparked an economic avalanche that threatens to turn the economy and markets as we know it upside down. With massive government deficits, analysts can’t seem to raise their targets for interest rates fast enough. Famed hedge fund manager Bill Ackman placed a huge bet on US Treasury yields continuing to rise to 5.5%, and so far he’s winning in spectacular fashion.
So why are interest rates rising so much? And what does it mean for the economy and financial markets? Let’s dig in.
Zero Interest Rates Were Not Sustainable
The 2010s were a unique time in economic history. After the 2008 financial crisis and subsequent European debt crisis, global central banks kept interest rates at zero (or less) for roughly 14 years. The US raised interest rates for a couple of years from 2017 to 2019 but ended up cutting them right back to zero due to COVID. In addition, central banks pursued quantitative easing policies to push down interest rates on mortgages to below the free market rate. This had even more effect on the economy.
Holding interest rates at or near zero had subtle but profound effects on the economy in the 2010s.
- It had the effect of making housing artificially cheap.
- It allowed venture capital/tech companies to lose billions chasing market share.
- And it allowed Wall Street to experience a monster bull market due to there being no real alternatives to stocks.
ZIRP also made certain business models unusually profitable. Friends of mine got rich by doing not much more than borrowing money cheaply and buying real estate. Decent execution of off-the-shelf business models like BRRR or the Airbnb hosting business model made making money a cakewalk. Even simply buying a property for a 3.5% mortgage in the 2010s and putting paint, carpet, and a tenant in it was good enough. During this time, vacant houses in California made about as much money from price appreciation (just by existing) as a typical household living there did by working.
Crypto is another business model that took off because of ZIRP. With the economic inputs of interest rates at zero, inflation at 2-3%, and government borrowing a bit unsustainable, putting some of your money in another currency like Bitcoin (BTC-USD) actually makes a ton of sense.
Of course, the mainstream economic theory here is that by fixing prices for loans at an unnaturally low level, the Fed was going to create shortages. For example, QE created an artificial housing shortage, despite there being a similar amount of per-capita housing in the US than there was before the 2008 crash. Still, consumer price inflation was low and everything was fine, at least until around 2019. And low rates were popular with the upper middle class, who saw their home equity increase and their 401ks rise. But, like America’s obsession with off-label Ozempic, it was too good to be true.
The Bond Vigilantes Are Back
The chaos of the pandemic brought these policies to a rapid end. Inflation surging from 2% to nearly 10% annually shattered the public’s trust in price stability. The public started panic buying goods, there were shortages of all kinds of necessary goods and services in the economy, and alternatives to the US dollar became cocktail party conversation. This more or less forced the Fed to act by raising interest rates and reversing its QE policies. Had they not done anything, inflation likely would have continued to rise, as it did in the 1970s.
Today, inflation is still significantly above target, and public trust in the currency is still not fully restored. The US government is running unprecedented levels of budget deficits, and fewer and fewer investors are willing to buy government debt. Fitch recently downgraded the US’s credit rating due to an “erosion of governance” and a lack of will to raise taxes. After getting burned by inflation, the market is hitting back.
To this point, the market has severely punished the prices of previously issued long-term bonds with low coupon rates. Long-term Treasuries (NASDAQ:TLT) have fallen off of a cliff.
This is simple supply and demand. The Treasury needs to sell trillions of dollars in bonds to cover its budget deficits, and the market has not been keenly interested in buying them. As long as government deficits go unchecked, interest rates will continue to rise. The so-called “bond vigilantes” from Beijing to Riyadh to New York are threatening to humble the US Treasury, voting with their keyboards to stop financing unsustainable levels of spending. Unless the Treasury either raises taxes or sharply cuts spending, the only way this interest rate freight train stops is with taxes being raised or spending being cut. While it’s theoretically possible that the White House could force the Fed to print money to buy the US debt, this would send an unmistakable message to our foreign creditors that it’s time to turn off the spigot. Long-term bonds actually aren’t a terrible value here if you trust the government’s ability to raise taxes and maintain 2% inflation, but that would require some sort of signal that they’re going to take deficits seriously first.
What Rising Interest Rates Mean For The Economy
Essentially, credit is getting more expensive and harder to get. Since household savings rates are near record lows, that’s a big problem for borrowers. By industry:
At a mortgage rate of 3%, a 20% down payment, and a standard 36% DTI, a homebuyer with $100,000 in income can qualify for a home worth $721,000. At 4%, it’s $649,000. At 5%, it’s $587,000. At 6%, it’s $533,000. At 7%, it’s $486,000. At 8%, it’s $445,000. Finally, at 9% mortgage rates a household with $100,000 in income can qualify for a home that costs $410,000, which is 43% less than they could at the 3% interest rate. This is purely mechanical from the change in financing costs, not due to opinion or sentiment. To maintain equilibrium at 9% mortgage rates, home prices would need to fall 43%.
This isn’t just theoretical. Mortgage rates have already soared from 3% to 7.5%, so 9% isn’t even that crazy given where we already are. This interest sits on top of large home price increases during the pandemic. The typical household looking to buy a house now with a mortgage is making an almost existential choice by signing up to pay bubble prices at 7-8% interest. It’s not going to end well, and DTI ratios are at or above their previous peaks in 2006-2007. If you’re in the top 1% of income earners then do whatever you want, but if you’re looking to buy a house and start a family you’re making a much bigger gamble than you might think.
It’s going to be hard for interest rates to go down with the deficits the government is running, so the most likely outcome here is some sort of housing crisis sooner rather than later. It’s not really a question of if, it’s rather a question of when. Consumers are not displaying enough elasticity to interest rates due to their bias, and it’s going to cost them. Just because you should call an all-in bet for $20 does not mean you should call it for $2,000. It’s the same with mortgages- housing was a great investment at 2016 prices and 2016 interest rates but a terrible one at today’s rates and prices.
The story isn’t too different for automakers. Because the vast majority of buyers need to finance their cars, sharply rising interest rates are bad news for automakers. While manufacturers are free to offer discounted financing, it cuts into their margins. Far fewer people can pay $90,000 for a truck at 6% or 7% for a 5-year loan than could at 2% or 3%.
March’s bank crisis was sparked by regional banks taking too much interest rate risk, and then rising rates burned them. Now, rates are back at fresh 52-week highs. Where are all of these banks now, and how much in losses have they sustained? The crisis caused rates to fall, allowing smart banks to get out from upside-down bets. For every bank that took decisive action to reduce interest rate exposure this spring, there are likely several that put their heads in the sand. While big banks are fine, I expect dozens more of these smaller banks to end up being taken over cheaply by competitors or closed by the FDIC over the next 12-18 months. Bad bets on commercial real estate and long-duration assets virtually guarantee this. This will not be the last you hear about regional banks!
This said, attrition in the banking industry could be an opportunity for well-run banks like JPMorgan (JPM).
The days of losing billions to grab market share are effectively over now that capital has a price. While the 2010s brought gains in innovation, they also brought hundreds of VC-backed companies with flimsy business models. Expect many of these companies to go out of business over the next 12-18 months. This is just common sense.
The S&P 500
Large-cap valuations are near-bubble highs despite bond yields rapidly rising. With the economy being “revolutionized” by skyrocketing interest rates, it’s worth considering whether you can meet your financial goals by taking less risk in bonds and cash. For every cloud, there is a silver lining and bad news for borrowers is good news for lenders.
Also, it’s not widely known but interest rates are priced into futures and options, which means that calls and long futures get more expensive, while puts and short futures get cheaper. Higher interest rates also accrue to short sellers who short stock, enforcing some discipline on the market by channeling capital away from junk companies to higher-quality, profitable companies.
Current valuations for large stocks are suspect. The S&P 500 (SPY) currently sits at roughly the 95th percentile in terms of its earnings. Stocks like Apple (AAPL) and Microsoft (MSFT) are trading for 30x earnings or more, while stocks like Tesla (TSLA), Amazon (AMZN), and Nvidia (NVDA) are trading for 50-100x. Historically these kinds of valuations don’t work out. On the other hand, you can get roughly 5.5% in money market funds (VMFXX), 5.5% in short-term bonds (VFSUX), and 4.4% tax-free in municipal bonds (VWALX). Will stocks ever get cheaper than they are now? Since stocks have almost never been more expensive than they are now from a valuation perspective, it seems likely that they’ll revert to the mean with bonds and cash offering better and better returns. Again, I think this happens sooner rather than later.
Will Interest Rates Go Back Down?
History of past inflation episodes in various countries tells us that higher rates and inflation will likely remain for 5-10 years. While a severe recession could bring balance back to the economy, this is hard to exploit because the assets that would benefit from lower rates (stocks, real estate) would likely have to get completely crushed first to set the conditions for another bull market from the bottom.
While realtors are shouting from the rooftops to get buyers to “date the rate and marry the house,” overpaying for assets with teaser rates and betting that interest rates will go down and make the deal pencil is something that has burned millions of people in the past. This time is likely no different. History also shows that jumbo mortgage rates in particular tend to go up in times of economic stress.
This also goes for the popular assertion that the economy will never slow down because unemployment is currently low. Consumption of food, services, and soft goods won’t crash per se due to higher interest rates, but the borrowing to buy stuff will crash. Housing and autos are the business cycle for consumers, and changes in these are how every business cycle starts and ends. Workers in these industries are the original source of unemployment shocks, and business investment operates on a similar cycle. This eventually trickles down to consumption, but it’s a slow process. Student loans kicking back in on October 1st may have a more immediate impact on spending, as student loan debt service is about 1% of the US national after-tax income.
You should care about rising interest rates because it greatly affects the fair value of assets. If you understand how interest rates affect asset pricing, you can be more “elastic” to changes in interest rates and use this to make money for yourself and reduce your risk. If you’re overly emotional or dogmatic, you’re more likely to end up paying the wrong prices for the wrong assets. To this point, rising rates are both a huge opportunity and a huge threat to investors. In a less dysfunctional world, interest rates should not have risen this much, and government budget deficits wouldn’t be as atrocious. But we have to make do with the world we have, so this is how I view things as likely to play out going forward.
Will interest rates continue to rise? If so, what will the effects be on the economy? Share your thoughts in the comments below!