What You Must Know About Interest Rates

The buzz has faded away.  The intoxicating effects of the mass money printing and debt binge during the coronavirus years has come and gone.  But the hangover remains.  And while the money printing has subsided – for now – the debt binge has continued.

The consequences of high consumer price inflation, massive government debt, and countless economic distortions, were never really worth it to begin with.  As the last of the stimulus is consumed and wasted away, a great reckoning awaits.

What will happen when the labor market rolls over and debt overloaded consumers lose their jobs?  We may soon find out.

In fact, longtime market analyst Gary Shilling sees a recession coming by the end of the year, with unemployment rising up to 7 percent.  He also believes stocks, which have been driven higher by speculation, could drop as much as 30 percent.  And that the decline could be violent.

“You look at all the kind of speculation that we’ve had out there, it’s indicative of a lot of overconfidence, and that usually gets corrected and corrected violently.”

As detailed last week, we believe the United States has entered a world of ever-rising interest rates.  Where interest rates will zig-zag higher for the next three decades – possibly longer.

The critical inflection point was hit in July 2020, when the yield on the 10-Year Treasury note bottomed out at just 0.62 percent.  This marked the end of the 39-year trend of falling interest rates.

However, when long secular movements in the credit market reverse, it is not always immediately clear.  Investors, having decades of experience within a certain paradigm, fail to understand the implications of the change that has occurred right under their noses.

Here’s what we mean…

Projecting the Past

Many investment gurus in the early 1980s were predicting the future while projecting the past.  After a decade of raging price inflation, the popular dogma was to pack one’s portfolio with gold coins, fine art, and antiques.

This was the proven, surefire way to preserve one’s hard-earned wealth from the ravages of inflation.  The recent past and simple logic pointed to higher and higher consumer prices.

Nixon had closed the gold window in 1971.  Prices had quickly spiraled out of control.  America, it seemed, was about to go full Weimar.

Howard Ruff, in his investment newsletter The Ruff Times, was predicting the dollar would soon turn to hyperinflationary ash, like conifer trees in a California wildfire.  It was inevitable.  And imminent!

But then something unexpected happened.  Ultra-high interest rates courtesy of Fed Chair Paul Volcker brought on a recession.  An inflection point was hit.  Consumer price inflation stabilized.  And a new trend of asset price inflation – including stock, bond, and house price inflation – was born…though it wasn’t immediately clear what was going on.

In September of 1981, the yield on the 10-year Treasury Note peaked at 15.32 percent.  Many investors thought yields would go higher.  Franz Pick declared “bonds are certificates of guaranteed confiscation.”

But then something remarkable happened.  Yields commenced a 39-year decline that ended in June 2020 with the 10-Year Treasury not yielding just 0.62 percent.

To be fair, there were a few true contrarians in the late 1970s who foresaw what was coming.  Gary Shilling was one of them.

On the Money

Rather than the consensus view that inflation would persist forever, Shilling suspected the U.S. was entering a long-term era of lower and lower interest rates and low consumer price inflation.  Under this backdrop, traditional inflation hedges would be dreadful…

…and debt based financial assets would be highly prosperous.

Shilling, having a deep conviction and wanting to warn investors, wrote a book about his important insight.  The book was first published in the early 1980s, and its title asked two significant questions: Is Inflation Ending?  Are You Ready?

The book’s sales were an utter flop.  Almost no one wanted to hear Shilling’s case.  There were only a handful of shrewd individuals who could actually fathom that consumer price inflation was dissipating.

The book’s forecast proved to be right on the money.  What’s more, Shilling also put his money behind his convictions.  By the mid-1980s he achieved financial independence through aggressive investment in the long bond.

Shilling’s astute call and capital deployment into the long-term decline in interest rates starting in the early 1980s is remarkable.  But what’s also remarkable is Shilling’s ability to successfully ride out this trend long after other big investors – like Bill Gross – bailed out.

Many investors thought interest rates had bottomed out in late-2008 at the depths of the great financial crisis.  Fed purchases of mortgage-backed securities and Treasuries, made possible by $8 trillion in credit created out of thin air, extended the trend until July 2020.

Cheap consumer products imported from China and cheap oil and gas from innovative hydraulic fracturing extraction techniques, also kept a lid on consumer prices.  But these sensations can no longer contain consumer prices like they did a decade ago.

What You Must Know About Interest Rates

Now interest rates are on the rise.  But just like their prior 39-year fall, interest rates won’t rise along a smooth, always predictable slope.

If you look at a long-term chart of the 10-Year Treasury yield, you will see the larger trend, along with violent countertrend spikes upwards or downwards.  These countertrend spikes can sometimes come as a surprise.

For example, there was the interest rate spike in 1994 that caught Robert Citron with his pants down.  Robert Citron, if you’ve never heard of him, was the treasurer for Orange County, California, for 25 years.

In 1994, Citron accomplished a remarkable achievement.  Using what Merrill Lynch called “step-up double inverse floaters,” he oversaw a $1.64 billion loss of public funds.  At the time, this resulted in the largest municipal bankruptcy in U.S. history.  And Citron was rewarded with jail time.

But Citron wasn’t the only one caught with his pants down by an unexpected upward spike in interest rates.  Several notable blowups include Long Term Capital Management in 1998.  And Lehman Brothers in 2008.

The point is, unlike 1981 to 2020, the long-term trend for interest rates is up.  Consumer price inflation is baked into the cake.  Cheap consumer goods from China where the kids now tang ping, and cheap oil and gas can no longer save the day.

Still, as experienced between July 2020 and the present, there will be episodic periods where interest rates fall.  Enjoy them while they last.

Perhaps the 30-percent decline in the stock market Shilling sees coming will temporarily drive interest rates down.  Nonetheless, 10-year Treasury yields are not going back to 0.62 percent.  Nor are they going back to 2 percent.

Those cheap money days are gone forever.  The Fed can resist it.  But it cannot stop it.

And like Citron, the U.S. Treasury will be caught with its pants down.

[Editor’s note: It really is amazing how just a few simple contrary decisions can lead to life-changing wealth.  And right now, at this very moment, I’m preparing to make a contrary decision once again.  >> And I’d like to show you how you can too.]

Sincerely,

MN Gordon
for Economic Prism

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