October wouldn’t be complete without a thrilling spooktacular surprise. The October 7 sneak attack by Hamas on Israel and Israel’s subsequent official declaration of war certainly fits the bill. But what else?
As we see it, the performance of the U.S. economy and financial markets over the next 6 months will be a function of consumer price inflation, interest rates, and oil prices. A new war in the Middle East has the potential to dramatically influence these central economic components.
To be clear, the rampant money printing from 2020-2022 never really ended. Yes, the Federal Reserve has hiked the federal funds rate 5.25 percent and has made incremental reductions to its balance sheet – drawing down from $8.9 trillion to $7.9 trillion.
But the federal government continues to borrow and spend like drunken sailors. The U.S. 2023 fiscal year deficit came in at $1.7 trillion. That amounts to over $4.6 billion of borrowing and spending per day.
All this borrowing and spending gets added to the national debt, which is now over $33.5 trillion. Factor in unfunded liabilities – including social security, Medicare Parts A, B, and D, federal debt held by the public, and federal employee and veteran benefits – and the debt jumps to over $194.6 trillion.
Putting a lid on consumer price inflation while deficit spending runs wild is nearly impossible. The rate of consumer price inflation, as measured by the consumer price index (CPI) or the Fed’s preferred personal consumption expenditure (PCE) price index, may have slowed from last year. But excluding a deep recession, these consumer price inflation metrics aren’t going back to 2-percent anytime soon.
Thus, interest rates will remain relatively high when compared to a few years ago. By this, a 10-Year Treasury rate of 4.98 percent isn’t high in a historical sense. In fact, it’s only slightly higher than the historical mean of 4.49 percent.
Nonetheless, a 10-Year Treasury rate of 4.98 percent is much, much higher than the historic low of 0.62 percent reached in July 2020.
Interest Rate Flux
The rapid change – the flux – in interest rates is what causes the issue for the economy and financial markets. The difference between today’s interest rates and those of three years ago is important in how it impacts debt, debt servicing, and asset prices.
As interest rates rise, borrowing money becomes more expensive. Monthly payments for everything from auto loans to residential real estate mortgages to the carrying of credit card debt have gone through the roof when compared to just a few years ago. There are countless ramifications.
Homeowners who have locked in mortgage rates of 2.65 percent cannot afford to sell. Businesses who borrow to cover short-term costs no longer generate the cash flow to service their debts at higher interest rates.
Growth plans that made sense when interest rates were at 3 percent, come up short at 6 percent. What were already razor thin profit margins cannot cover the gap.
Ultimately, higher interest rates lead to lower asset prices. This has already happened in the bond market, where prices move inverse to interest rates.
For example, the iShares 20 Plus Year Treasury Bond ETF, TLT, currently stands at $82.77. That’s down from the $171 high that was reached in July 2020, when yields hit an all-time low, and amounts to over a 51 percent decline. This also represents the greatest Treasury bear market that’s ever occurred.
Stocks and residential real estate are both extremely overvalued. As interest rates remain relatively high, these assets should adjust downward to balance out the effect of higher borrowing costs. However, the dynamic nature of these markets will make for an adjustment that’s less uniform than the Treasury market.
Wouldn’t It Be Nice?
Aside from deflating asset prices, rapid interest rate flux is leading to a variety of consequences. The Fed’s artificially cheap credit from 2009 to 2022 lured individuals, businesses, and governments to take on massive amounts of debt.
Now, at higher interest rates, they’re facing a world of hurt. Delinquencies on auto loans, credit cards, and consumer loans are at their highest levels in a decade. As payments are missed, stress builds in the banking system.
The potential for more and more debt going bad is a growing concern. At some point the number of bad loans overwhelms the number of good loans. As more and more debt falls into arrears, the likelihood of a major banking crisis increases.
Moreover, even if debts are paid, extreme interest rate flux has shredded bank balance sheets. Peter Schiff, CEO of Euro Pacific Capital, Inc., recently summed up what’s going on at Bank of America, tweeting:
“For the 1st half of the year Bank of America reported pre-tax income of $48.1 billion, yet ignored an additional $95.9 billion loss on its “held-to-maturity” securities. So the bank actually lost $47.8 billion. It’s in worse shape now than it was when it was bailed out in 2008.”
Again, as rates go up, bond prices go down. Bank of America, like many other big banks, is holding bonds that are significantly underwater. Thay cannot sell them without booking extraordinary losses. Assuming the decline of TLT is a representative indicator, banks are in big trouble.
Who really knows what will happen? Perhaps consumer price inflation will abate. Maybe interest rates will fall and will, thus, alleviate debt burdens across the board.
As Brian Wilson remarked just before he went to cloud cuckoo land, “wouldn’t it be nice?”
Indeed, avoiding a mega banking crisis would be nice. What else would be nice is not having a mouth drooling geezer in the White House.
President Biden is a career politician. His modus operandi is centered around making tactical decisions that increase his political power.
Unfortunately, the decisions Biden makes generally are not for the benefit of the people he governs. One recent tactical decision involved draining the nation’s strategic petroleum reserve (SPR).
The intent of the SPR is to have an emergency cushion to soften the effects of supply disruptions. President Biden, however, used the SPR for personal political gains. Specifically, he released oil from the SPR prior to the 2022 mid-term elections to lower gas prices at the pump so his Democratic colleagues in Congress could remain in power.
The SPR currently stores about 351 million barrels of oil. When President Biden assumed office in January 2020, the SPR had 638 million barrels of oil. Hence, Biden has drained off about 45 percent of the nation’s emergency oil supply for non-emergency purposes.
If you recall, the impetus for the SPR was the Arab oil embargo of 1973-74, which was in retaliation for U.S. support of Israel during the Yom Kippur War. The embargo skyrocketed gas prices in America and forced Americans to wait for hours to fill up their cars. As a result, Congress created the SPR in 1975.
Now, 50 years later, there’s another war in Israeli war, and thanks to Biden’s political decisions, the SPR is at a 40-year low. In other words, the cushion for softening a supply disruption has been greatly diminished.
On October 6, the day before the Hamas invasion, the price of a barrel of West Texas Intermediate (WTI) crude – the light sweet stuff – was $82.79 per barrel. At market close on October 20, it was at $89.16 per barrel – roughly 7.69 percent higher than the price on October 6.
For now, the oil market appears to be slightly anticipating the risk of an oil supply disruption. Biden, for his part, has made another tactical decision. He’s lifted oil sanctions on Venezuela.
So, too, since October 6 the price of gold has increased from $1,820 per ounce to over $1,974 per ounce – or roughly 8.46 percent. What unpleasantness is gold anticipating?
War, famine, pestilence, bank failure, market crash, complete societal breakdown, a cluster of ferocity…what will it be?
Remember, the month is still young. Biden’s Commander and Chief. Everything’s spooktacular.
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for Economic Prism