Sometimes things don’t go as planned…
On September 18, the Federal Reserve cut the federal funds rate by 50 basis points. This is the first time the Federal Reserve has lowered interest rates since March 16, 2020. Aggressive interest rate cuts have been instigated by Federal Reserve Chairman Jerome Powell and others like Elizabeth Warren. “Behind the curve.”
Over the past three weeks, something unexpected has happened at the Federal Reserve. The 10-year Treasury yield did not follow the Fed’s rate cuts. In fact, it was the opposite. It went up.
This week, the 10-year Treasury yield exceeded 4% for the first time since July 31. The two-year maturity government bond yield also exceeded 4%. So the Treasury market is not cooperating with the Fed’s demands for cheaper credit.
Could Warren be wrong and the Fed eventually fall behind? Was September’s 0.50% interest rate cut a policy mistake? Will the Fed compound its mistakes with further rate cuts in November?
Remember that bond prices move inversely with yields. Therefore, as yields rise, bond prices fall. As Treasury yields rise, borrowing costs to finance government debt rise. Rising Treasury yields affect everything from mortgages to corporate loans.
In fact, the reason the Fed cut interest rates on September 18th had nothing to do with the Fed cutting interest rates. The primary intention of the Fed’s interest rate cuts was to ease the Treasury’s ability to finance Washington’s massive debt.
But as Treasury yields rise, debt financing becomes more expensive. And as interest rates rise, paying interest on debt that will exceed $1 trillion in fiscal 2024 will become a bigger part of Washington’s bloated budget.
what’s the matter?
Limits of Government Intervention
The Federal Reserve can exert extreme and powerful influence on credit markets. But the Fed doesn’t completely control it. The fact is that the Fed’s intervention in credit markets plays a secondary role in the overall long-term rise and fall of the interest rate cycle.
For example, the 10-year Treasury yield peaked above 15% in September 1981. Over the next 39 years, interest rates generally fell. Occasionally, there were cases where the rate of increase rose sharply. However, the long-term interest rate trend showed a downward trend.
The Fed’s cunning friends have taken advantage of the long-term decline in interest rates to boost stock and bond prices. Investors have learned that they can count on ‘Fed puts’ to stimulate both stock and bond markets. The Fed’s put options typically involve cutting interest rates whenever the S&P 500 index falls 20%.
These centrally coordinated interventions had two effects: market distortions that were observable between 1987 and 2020. First, the explosion in liquidity has raised the floor for how much the stock market will fall. In other words, it is the put option effect. Second, because bond prices move inversely with interest rates, interest rates lower the prices of inflated bonds.
Lowering interest rates also allows overindebted businesses, individuals, and the federal government to refinance at lower borrowing costs. Thanks to the Fed’s foot duct, the central bank has implicitly implemented countercyclical stock market monetary stimulus since the mid-1980s.
That world ended in July 2020, with the 10-year Treasury yield hitting a record low of 0.62%. By our estimates, this puts borrowing costs at their lowest in 5,000 years. For nearly 40 years, savers have had less and less capital. On the other hand, a crazy person addicted to leverage became rich.
long-term interest rate trends
The lunatics were given the opportunity to borrow large amounts of money, invest it in assets such as real estate or marginal businesses, and then refinance at lower interest rates every few years. Likewise, the waste maniacs in Congress have been able to run massive debt tabs at increasingly lower borrowing costs.
As interest rates fall, the cost of servicing debt also decreases. At the same time, asset prices (in dollar terms) plummeted.
Interest rates have increased across the board since July 2020. On Wednesday, the yield on 10-year Treasury bonds topped 4.09%. This is still a low figure from a historical perspective. In fact, the 10-year Treasury bond interest rate is average 4.49% Over the past 150 years.
Nonetheless, the 10-year Treasury yield is 4.09%, compared to 0.62% just three years ago. Such major changes in such a short period of time are causing major problems.
The purpose of the Fed’s put options was more than just bailing out stock and bond investors. The Fed’s main purpose was to bail out big banks and corporations and provide cheap credit to Washington. To be honest, American financial markets have been rigged for at least 37 years.
But now, with long-term interest rates trending upward, the Fed’s ability to stimulate stock and bond markets during a financial panic has become more limited. Moreover, the ability to supply cheap credit to Washington is more limited. This is why Treasury yields have risen since the Federal Reserve’s recent interest rate cut.
The risks of moving from an era of historically low interest rates to one approaching historical averages remain underestimated. There were already some initial growing pains. As bond prices plummeted from mid-2020 to the end of 2023, strategist Bank of America calls it this. “The biggest bond bear market in history”
But this bond bear market could continue for decades.
past mistakes
Since the end of 2023, 10-year Treasury yields have eased and fallen slightly. Almost everyone took this reprieve to mean that the worst was over. They are mistaken. The long-term trend remains upward. And when interest rates resume rising, there will be more people grinding their teeth.
If you’ve ever looked at one place for several minutes chart If you look at historical 10-year Treasury yields, you can see trends unfolding over decades. The last time an interest rate cycle bottomed was in the early 1940s. At the time, the low inflection point for 10-year Treasury bonds was a yield of about 2%. After that, interest rates generally rose over the next 40 years.
What few living souls remember is that the Fed’s adjustments to the federal funds rate have vastly different impacts on the falling part of the interest rate cycle and the rising part of the interest rate cycle.
Between 1987 (the advent of the Fed put) and 2020, whenever the economy slowed, the Fed cut interest rates to stimulate demand. In this environment of moderating inflation, credit markets have limited the negative consequences of the Fed’s actions.
Certainly, asset prices have risen, and income has stagnated. But consumer prices haven’t gone completely off the charts. Cheap oil and cheap consumer goods from China also helped moderate consumer price inflation during this period. The Federal Reserve took this to mean that it had tamed the business cycle. This couldn’t be further from the truth.
As evidenced in the 1970s, the Fed’s interest rate policy was repeatedly disastrous during the upturn in the interest rate cycle after the United States defaulted on the Bretton Woods Agreement. During that decade, Fed policymakers were politically unable to deal with interest rate increases. And efforts to keep the federal funds rate artificially low to stimulate the economy have not had the desired effect.
In this scenario, currency inflation drives consumer price inflation, as we have experienced since 2020. Fed Chairman Powell’s decision to cut interest rates by 50 basis points on September 18 is already being seen as a repeat of the mistakes made by Arthur Burns in the 1970s.
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minnesota gordon
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