Mistakes from the Past

Sometimes things don’t work out as planned…

On September 18, the Federal Reserve cut the federal funds rate by 50 basis points. This was the first time the Fed cut rates since March 16, 2020. The aggressive rate cut was goaded on by people like Elizabeth Warren, who said Fed Chair Jerome Powell was “behind the curve.”

Over the last three weeks something unexpected by the Fed has happened. The yield on the 10-Year Treasury didn’t follow the Fed’s rate cut down. Rather, it did the opposite. It went up.

This week the yield on the 10-Year Treasury spiked above 4 percent for the first time since July 31. The yield on the 2-Year Treasury note also topped 4 percent. Thus, the Treasury market is not cooperating with the Fed’s desire for cheaper credit.

Could it be that Warren was wrong, and the Fed wasn’t behind the curve after all? Was September’s 0.50 percent rate cut a policy mistake? Will the Fed add to its mistake with an additional rate cut in November?

Remember, bond prices move inverse to yield. So, as the yields increase, bond prices fall. Rising Treasury yields result in higher borrowing costs for financing government debt. Rising Treasury yields also affects everything from mortgage loans to corporate borrowing.

In reality, the reason for the Fed’s September 18 rate cut had nothing to do with the Fed being behind the curve. The primary intent of the Fed’s rate cut was to ease the Treasury Department’s ability to finance Washington’s massive debt.

But with Treasury yields increasing, financing the debt becomes more expensive. And as interest rates rise, paying the interest on the debt – which will exceed $1 trillion in fiscal year 2024 – becomes a larger share of Washington’s bloated budget.

What’s going on?

Limits to Government Intervention

The Fed may have an extreme and heavy-handed influence over credit markets. Still, the Fed doesn’t entirely control it. The fact is Fed credit market intervention plays second fiddle to the overall long-term rise and fall of the interest rate cycle.

For example, the 10-Year Treasury rate peaked at over 15 percent in September 1981. Over the next 39 years, interest rates generally went down. There were occasional spikes to the upside. But the long-term interest rate trend was downward.

The crafty fellows at the Fed used the long-term slide in interest rates to boost stock and bond prices. Investors were taught that they could count on the ‘Fed put’ to levitate both the stock and bond market. The Fed put generally involved slashing interest rates whenever there was a 20 percent decline in the S&P 500.

This centrally coordinated intervention had a twofold effect of observable market distortions between 1987 and 2020. First, the bursts of liquidity put an elevated floor under how far the stock market would fall – the put option effect. Second, the interest rate cuts inflated bond prices, as bond prices move inverse to interest rates.

Slashing interest rates also allowed overindebted businesses and individuals – and the federal government – to refinance at lower borrowing costs. Thanks to the Fed put, the central bank has been running an implicit program of counter-cyclical stock market monetary stimulus since the mid-1980s.

That world ended in July 2020, when the 10-Year Treasury rate hit a low of 0.62 percent. By our estimation, this marked a 5,000 year low for borrowing costs. Throughout that nearly four-decade duration, savers got less and less on their capital. On the other hand, leverage addicted madmen got rich.

Long Term Interest Rate Trend

Maniacs were gifted the opportunity to borrow gobs of money, plow it into assets – like real estate and marginal businesses – and then refinance every several years at lower and lower rates. Similarly, wastrel lunatics in Congress were able to run up a mega debt tab at lower and lower borrowing costs.

As rates fell, debt servicing costs fell. At the same time, asset prices – in dollar terms – went to the moon.

Since July 2020, interest rates have generally increased. On Wednesday, the 10-Year Treasury rate topped 4.09 percent. This is still low from a historical perspective. In fact, the 10-Year Treasury rate has averaged 4.49 percent over the last 150 years.

Nonetheless, a 10-Year Treasury rate of 4.09 percent is much, much higher relative to the 0.62 percent of just three years ago. This big change over such a short period is causing big problems.

The purpose of the Fed put was about much more than just bailing out stock and bond investors. The primary purpose of the Fed put was to bail out big banks and big businesses, and to keep Washington supplied with cheap credit. By all honest accounts, U.S. financial markets have been rigged for at least 37 years.

Yet now that the long-term interest rate trend is up, the Fed is more limited in its ability to levitate the stock and bond market in a financial panic. Moreover, it’s more limited in its ability to supply cheap credit to Washington. This is why following the Fed’s recent rate cut Treasury yields went up.

The dangers of moving from an era of historically low rates to an era approaching historically average rates remain underappreciated. There have already been some initial growing pains. As bond prices rapidly fell between mid-2020 and late-2023, strategists at Bank of America called it “the greatest bond bear market of all time.”

Yet this bond bear market could go on for several more decades.

Mistakes from the Past

Since late-2023, the 10-Year Treasury yield has moderated and slightly declined. Nearly everyone has taken this reprieve to mean the worst is behind us. They’re mistaken. The long-term trend is still up. And as the upward climb in interest rates resumes, there will be more weeping and gnashing of teeth.

If you’ve ever taken a few minutes to stare at a chart of historic 10-Year Treasury yields, you will see that trends unfold over several decades. The last time the interest rate cycle bottomed out was during the early-1940s. The low inflection point for the 10-Year Treasury note at that time was a yield somewhere around 2 percent. After that, interest rates generally rose for the next 40 years.

What hardly a living soul remembers is that the Fed’s adjustments to the federal funds rate have drastically different effects during the rising part of the interest rate cycle than during the falling part of the interest rate cycle.

Between 1987 – with the advent of the Fed put – and 2020, each time the economy went soft, the Fed cut interest rates to stimulate demand. In this disinflationary environment, the credit market limited the negative consequences of the Fed’s actions.

Certainly, asset prices increased, and incomes stagnated. But consumer prices did not completely jump off the charts. Cheap oil and cheap consumer goods from China also helped moderate consumer price inflation throughout this period. The Fed took this to mean it had tamed the business cycle. This couldn’t be further from the truth.

During the rising part of the interest rate cycle, as demonstrated in the 1970s, after the U.S. defaulted on the Bretton Woods Agreement, Fed interest rate policy was repeatedly disastrous. Over that decade, Fed policy makers were politically incapable of staying out in front of rising interest rates. And their efforts to hold the federal funds rate artificially low, to boost the economy, didn’t have the desired effect.

In this scenario, and as we’ve experienced since 2020, monetary inflation produced consumer price inflation. Fed chair Powell’s decision to cut rates on September 18 by 50 basis points is already looking to be a repeat of the mistakes made by Arthur Burns in the 1970s.

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Sincerely,

MN Gordon
for Economic Prism

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