What is the “New Normal” Interest Rate Curve?

The recent Federal Reserve increase in short term rates to fight inflation, is seen by some to be a “temporary” increase.  At some point when relevant price indices have fallen into an acceptable range, the Fed will settle back to some lower initial reference point such as 1%.  Interest rates will then revert to the pattern of the decade of the 2010-2020 pre-covid era.

But what if that assumption is wrong?  What if the Fed’s definition of normal, a 2% real rate of interest on top of an assumed 2% long term growth rate, means the overnight baseline is closer to 4%?

Today the overnight rate is 3%.  The Fed is promising at least two, maybe three, more rate hikes this year? How would  a “new” 4% normal affect the rest of the curve?   What pricing and investment assumptions from the most recent decade would have to be rethought?

What If  Recent Past Rates Are Abnormal?

A commentator on MSNBC observed this past week, that interest rates have not been “market determined” since at least 2008.  He commented that the Fed policy of low overnight rates and quantitative easing created an artificially low interest rate curve to respond to economic crisis and to get the economy growing.   Some would move the starting point back to the post 9/11 era of lowered rates to avoid a recession following the attack on the World Trade Center.

Two analysis can help address this question of what the “normal” post Covid, inflation fighting yield curve might be like.

One is a May 4, 2022 article by Tony Yiu, which asked Why  was there Basically No Inflation in the 2010’s?  Here is part of his analysis.

Why did inflation not arrive earlier during say 2014? Or 2017? After all the Fed had been stimulating the economy and markets using easy monetary policy and QE since 2008. So why did inflation not spike until a few months ago?

So back to the question of where was all this inflation in the 2010s? My theory is that during most of the past decade, the stock market (both private and public), the real estate market, and new markets like crypto acted like a massive sponge that soaked up all the money that could have otherwise gone towards pushing up the prices of goods and services.

This created a positive feedback loop where:

  1. Stock prices and home prices go up incentivizing people to put more money in the stock and real estate markets.
  2. Money going into asset markets instead of chasing goods and services keeps inflation low (home prices are ironically not a part of CPI).
  3. Low inflation allows the Fed to keep interest rates low, which stimulates credit growth (along with rising collateral values).
  4. Credit growth causes even more stock and home price appreciation as significant amounts of the newly borrowed money gets plowed back into asset markets. And back to step 1 to repeat the cycle all over again.

Notice two things about this. First, this feedback loop results in the financial economy getting increasingly bigger than the real economy as money keeps getting sucked into well-performing assets like stocks and real estate.

And second, it’s not just low inflation and low interest rates that cause asset prices to go up. But because of feedback, there’s a causal effect in the other direction as well where increasing asset prices help soak up money keeping inflation low.

This positive loop obviously can’t go on forever. At some point, like the players in the casino, people will start to realize that there’s just not enough real stuff to go around (and not enough future earnings to justify the valuations). People seem to be finally realizing this based on the massive declines of stocks like Zoom and Netflix.

This realization kicks off a rush for the exits and a decline in asset prices. And because rising asset prices helped keep inflation low, the reversal into a negative feedback loop forces all that soaked up money to pour back into the real economy to chase goods and services, thus higher inflation (and higher interest rates).

Finally, a unique aspect of this current selloff is that where Treasury bonds are usually a place that investors can escape to during a market downturn, they’re part of the problem this time. Near zero nominal yields (and extremely negative real yields) mixed with high inflation makes Treasury bonds all risk and no reward (I first wrote about this here).

Long-Term Mortgage Market Rates

The decade of 2010 also saw the lowest 30-year mortgage rates ever, fueling a housing boom with double digit price appreciation.

Jim Duplessis of Credit Union Times published a September 26 article which examined the outlook as current mortgage rates hit a 20-year high.    His analysis with the relevant data link follows:

Rates in the 7% neighborhood might feel high for those who started buying houses in the last 10 years but they are on the low side for the past 50 years, based on Freddie Mac data published by the St. Louis Fed.

For more than half of the 2,687 weeks from April 1971 through Sept. 22, the rate was at least 7.4%. The median was 9.1% from 1971 to 1999 and 4.8% from 2000 to the present.

Rates peaked at 18.63% for the week ending Oct. 9, 1981 when the Fed under Chair Paul Volcker was battling inflation that had started during the Vietnam war. Volker’s aggressive rate hikes sent the nation into a recession, but knocked back inflation.

The lowest rates from 1971 to 1999 were 6.49% for the week ending Oct. 9, 1998, when the nation was in an economic boom. The lowest over the past 51 years was 2.65% for the week ending Jan. 7, 2021 at the peak of the refinance boom that vanished as rates rose this year to tame inflation.

A “New Normal”

Both analyses suggest the most recent two economic decades are an aberration in terms of a significantly lowered interest rate yield curve.

The efforts to reduce inflation will be a central part of where current rates end up.  But then what?

History suggests that the yield curve will shift to a higher level versus what many consumers, businesses and investors grew accustomed to since 2008.

There are other factors as well.   There is increasing evidence that lower rates while seemingly consumer friendly, do distort the allocation of economic gains disproportionately to higher income individuals while incentivizing multiple forms of financially driven wealth (speculative) strategies.

Anyone can predict the future.  No one knows it.   But believing that recent experience is the best or only guide to future rates, would appear a much too narrow perspective.

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